Capital Markets Update #6

We were reading the recently published Federal Reserve Financial Stability Report and it struck us on what strong footing the US financial system rests.  Achieving financial stability across the many legs of the US economic stool, while promoting 4.4% annualized Q3 2025 GDP growth (BEA), 4.9% Q3 2025 productivity growth (BLS), 1.3% Q3 2025 real wage growth (FRED) and a 17.9% total return in the S&P 500 (CY 2025) warrants careful consideration and attentiveness to the underlying forces driving success.

We’re not pollyannish; there are plenty of sources of risk in the world, primarily geopolitical risk with a touch of bubble talk around AI valuation lift.  Natural skepticism and a nimble footing remain valuable.  But, we took a look at the 2025 Financial Stability Report and thought we’d transcribe a few takeaways.

For context, the Federal Reserve categorizes financial stability risk into four main classes: asset valuations, borrowing by businesses and households, leverage in the financial sector and funding risks (basically liquidity risks at banks).  

Regarding asset valuations, while the forward PE multiple for the S&P 500 has increased materially from ~18x from 2016 – 2018 to ~22x today, forward year-over-year earnings growth guidance today is closer to 14% versus a the highly volatile earnings outlook pre-covid.  From 2015 – 2019, forward earnings growth guidance flexed from 0% to 20% then back down to 2% (all earnings and PE data according to Yardeni).  Without spending any time on a bottoms-up valuation approach, it’s understandable that volatility inhibits value or, conversely, perceived durability around future strong earnings drives value. To be clear, we’re not trying to defend equity market pricing, perhaps just contextualize it a bit.  Balance sheets for S&P 500 companies remain pretty strong.  You can look at the fact that IG spreads are at all-time tights (+75bps), high-yield bond spreads are near all-time tights (+275 bps) and OID’s are stable across the universe.  However, bond spreads don’t perfectly capture the “fortress balance sheet” concept; believe it or not, actual balance sheet health is a tough metric to pin down, in the aggregate. What we did find was that total interest expense paid by non-financial S&P 500 corporates (about 410 companies, according to CalcBench) in Q2 2023 was about $54B against $362B of net income for the same group.  Net income is net of interest expense, by the way.  So, interest was a minimum 6.7x covered by net income in Q2 2023, while rates were at their peak.  In theory, the story is more compelling now given rates have dropped and earnings have grown, depending on how you account for depreciation on AI CapEX. 

We’ve written quite a bit about generic consumer health.  Our view is that the consumer remains exceptionally strong, in aggregate, by historical standards.  What we will note is that the Fed publishes one of the more outstanding data series available, which fails to attract much attention but is eminently useful.  The series is called the Fed’s Debt Service Ratio (the “DSR”).  Basically, it takes the national mortgage debt yield (total quarterly mortgage payments divided by total quarterly consumer income) and adds it to the consumer debt yield (total quarterly consumer debt payments divided by total consumer income).  This combined Debt Service Ratio is a fantastic approximation as to consumer’s current debt load as a function of total income.  The Q3 2025 DSR was approximately 11.3%, which is down from 11.7% in Q4 2019 and 15.5% in Q4 2006 before the GFC.  Don’t forget, Fed Fuds rates were at 1.75% in Q4 2019 vs 3.75% today, which gives you a sense as to how much incomes have grown to drive down the DSR from 2019 to today.   Yes, 92% of mortgages are fixed (St. Louis Fed), but 8% aren’t and neither is the $5.1 trillion of consumer debt (FRED). 

The final comment we’ll make to our hard-fought present state of financial stability is praise for regulators and our political system in the aftermath of the GFC.  You might not have expected that.  Our view is the present regulatory regime, which includes annual stress tests across a variety of economic scenarios, stringent capital reserves held against risk assets, and constant conflict between regulators and banks as to what’s fair benefits the American, if not world, economy.  In 2023 we saw a deposit run, some bad loans and a handful of poorly managed risk hedges take down Credit Suisse, Silicon Valley Bank, Signature Bank and First Republic Bank, all in a manner of months.  And yet the industry survived, in some ways without much issue.  Despite the success, a hawkish contingent pushed an even more stringent bank regulatory framework through the Basel III Endgame proposal. Ultimately, the debate raged and in November 2025, the FDIC and Fed issued a final regulatory determination actually loosening capital reserve requirements.  You can look at this two ways. The skeptic might assume the existing conservative banking capital structure enabled confidence in the industry, which ultimately helped “contain the explosion” during events like Q2 2023 bank runs.  The supporter might note we took the data, learned from the events of 2023 and reformed the regulatory regime to reflect the takeaways.  Regardless, we see the constant debate as healthy conflict which ended with a sane response.  The stress test framework put in place by the Fed and FDIC is strong, its reasonable and, in many ways, underpins all of the successes and achievements we’ve outlined throughout this piece.