Bank of England flags danger of ‘sharp correction’ in asset prices as global markets reach record highs

Global markets have put too much weight on the good news in recent months and are now at risk of a “sharp correction,” the Bank of England warned today. 

In the latest meeting of the Financial Policy Committee (FPC), Bank officials flagged concerns that asset prices could plummet if the global economy does not perform as economists expect. 

Investors were “putting less weight on risks to growth or the path of interest rates necessary to bring inflation back to target sustainably,” officials warned. 

Since the FPC’s last meeting in December, the economic outlook has improved as inflation has receded and central banks prepare to cut interest rates.

Asset valuations across a range of markets have continued to rise in the last few months, with many global equity markets reaching record highs. 

Risk appetite in credit markets also remained strong while high-yield loan spreads had fallen to around two-year loans. 

FPC members were concerned that markets have put too much emphasis on the positive trends without factoring in the potential risks to growth. These risks include interest rates remaining higher for longer than expected or a deterioration in geopolitcal conditions. 

“The risk of a sharp correction in a broad range of assets and a widening of credit spreads…had therefore grown since 2023”, in the fourth quarter it said. 

The Bank warned these risks could be “amplified by longstanding vulnerabilities” in market-based finance (MBF), often known as shadow banking. 

MBF includes a range of financial institutions, such as private equity firms and hedge funds, which do not face the same regulations as traditional banks. The sector has grown massively since the financial crisis on the back of lower interest rates. 

Private equity could be particularly vulnerable to a fall in asset prices, officials warned, due to the lack of transparency around asset valuations in firms’ portfolios and the interconnectedness of the sector. 

Any disruption in MBF could potentially lead to “dysfunction in core markets, amplifying any tightening in credit conditions”. 

Looking forward the FPC will “continue its evaluation of risks from private equity and interconnected markets”. It will publish a further assessment of these risks in June. 

Despite these risks, officials suggested “the outlook for UK households has improved somewhat since 2023 Q4” as inflation has come down. 

While arrears will continue rising “marginally” over the next two years, they will remain comfortably below pre-financial crisis levels. 

The UK banking system meanwhile remains robust and could continue to lend to businesses and households even if financial conditions deteriorated significantly, the FPC judged. 

It decided to maintain banks’ countercyclical capital buffer (CCyB) at two per cent. The CCyB is rainy day buffer which can be released during times of stress to help banks lend to the economy.