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Fed warns assets face big declines if virus goes unchecked

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The Federal Reserve is warning that asset prices in key markets could still take a hit if the coronavirus pandemic’s economic impact worsens in coming months.

Most assets have maintained strong levels so far, as investor appetites increased and the government intervened to support the financial system, according to the Fed’s twice-yearly Financial Stability Report released Monday. Signs of weakness are showing in commercial real estate -- which has been particularly sensitive to the pandemic -- where property values have begun falling, according to the report.

The report also said that hedge fund leverage has remained elevated and that life insurers are reaching debt levels not seen since the 2008 financial crisis.

“Uncertainty remains high, and investor risk sentiment could shift swiftly should the economic recovery prove less promising or progress on containing the virus disappoint,” the Fed said in the report, which is meant to spotlight emerging threats to the financial system. “Some segments of the economy, such as energy as well as travel and hospitality, are particularly vulnerable to a prolonged pandemic.”

U.S. equities markets soared Monday on news of progress toward a Covid-19 vaccine and in response to the possible end of political instability with Democrat Joe Biden’s election victory over President Donald Trump. The Fed’s report expresses wariness over potential shocks that could move markets in the other direction if progress stalls.

‘Highest Vulnerability’
A vaccine that lessens the virus’s threat would be vital to commercial real estate. The pandemic has been a gut punch for retail, office and lodging properties, leaving them with the “highest vulnerability” and much to gain if people begin working, shopping and traveling again at pre-Covid levels, the Fed said.

“If the pandemic persists for longer than anticipated -- especially if there are extended delays in the production or distribution of a successful vaccine -- downward pressure on the U.S. economy could derail the nascent recovery and strain financial markets,” the report said. “Given the generally high level of leverage in the non-financial business sector, prolonged weak profits could trigger financial stress and defaults.”

The Fed also called for wholesale reform of the non-bank sector in the wake of the mayhem that swept through the financial markets in March as the economy was locked down to combat the spread of the coronavirus. The sector, which includes hedge funds and money market funds, mortgage providers and other non-bank financiers, needs “structural fixes in the longer term” to lessen the risk of a repeat of such turmoil, the Fed said.

Lael Brainard
That call was echoed in a statement by Fed Governor Lael Brainard, who has led the central bank’s stability reporting efforts and is being tipped by some to become Treasury secretary under Biden.

“The resurgence of fragility and funding stress in the same nonbank financial sectors in the COVID-19 crisis and the global financial crisis highlights the importance of a renewed commitment to financial reform,” Brainard said, citing prime money market funds and open-ended funds that invest in illiquid assets.

Brainard said the March turmoil also highlighted the importance of exploring Treasury market reform, including wider use of central clearing in cash markets.

For the first time, the Fed also included the risks of climate change in the stability report. The agency noted that severe, abrupt storms could lead to market swings -- including instant changes in the value of real-estate harmed in a disaster. The trend toward higher global temperatures “adds a layer of economic uncertainty and risk” that the central bank is trying to incorporate into its thinking.

Fed Governor Randal Quarles, the central bank’s vice chairman for supervision, will tell the Senate Banking Committee at a hearing Tuesday that banks “are well positioned to serve as a bulwark against broader financial and economic stress” if the economy continues to sour, according to his prepared remarks.

Bloomberg News
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