The value of financial assets could be dealt a heavy blow if investors react harshly to signs that the economic recovery is weakening or that inflation is more persistent than expected, the Bank of England has warned.
Amid growing evidence of greater risk taking from investment banks, the BoE’s Financial Policy Committee said on Friday that ‘risky asset prices have increased’ and ‘asset valuations appear elevated relative to historical norms’.
Asset prices – including equities, corporate bonds and property – have been buoyed since the market shock of Covid-19 by central banks cutting interest rates and spending billions of dollars to shore-up economic activity.
The Bank of England warned on Friday that a sharp correction could be on the cards
An improved economic outlook globally has also contributed to market bullishness.
But the BoE warned that valuations ‘could correct sharply if, for example, market participants re‐evaluate the prospects for growth, inflation or interest rates’.
It added: ‘Any such correction could be amplified by vulnerabilities in market‐based finance that were exposed in March 2020.
‘This could have consequences for market functioning and financial conditions, and hence the real economy.’
Inflationary pressure on prices has continued for longer than the bank had first anticipated. It now expects the CPI rate to exceed 4 per cent by year-end – double its target rate.
The bank’s new chief economist Huw Pill told MPs yesterday: ‘The magnitude and duration of the transient inflation spike is proving greater than expected.
But he said the ‘inflationary pressures’ pushing prices higher ‘should subside’ as the economy recovers from the coronavirus crisis.
Economic growth has also been disappointing, with the BoE recently revising down its forecast for Q3 GDP growth to 2.1 per cent from 2.9 per cent.
These risks to financial markets, the BoE said, have been exacerbated by risks in leveraged loan markets, which ‘continue to build’ globally.
It added: ‘There are signs of continued loosening in underwriting standards and increased risk-taking in some investment banking businesses.
‘These risks can affect UK financial stability through the direct impact on banks and the indirect impact of losses spreading through other parts of the global financial system.’
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