The International Monetary Fund has warned that the ongoing disconnect between financial markets and the real economy could lead to a correction in asset prices.
In recent months, equity markets have rallied despite troubling real-world events. The world is grappling with the coronavirus health emergency that has taken the lives of almost 500,000 people, according to John Hopkins University data, and threatens to cause an unprecedented economic crisis. In addition, there is social unrest in many advanced economies as citizens demand a more equal society, which could hit investor confidence.
Recent data indicates a deeper-than-expected downturn, the Fund added, but markets appear unfazed: the S&P 500 enjoyed its largest 50-day rally in history in early June.
“This disconnect between markets and the real economy raises the risk of another correction in risk asset prices should investor risk appetite fade, posing a threat to the recovery,” the IMF said Thursday in its updated Global Financial Stability report.
A correction is defined as a 10% or more decline in the price of an asset or index.
The Fund said that valuations currently looked stretched across many different markets.
“According to IMF staff models, the difference between market prices and fundamental valuations is near historic highs across most major advanced economy equity and bond markets, though the reverse is true for stocks in some emerging market economies,” it said.
Triggers for a shift in market sentiment could include a second wave of coronavirus infections, further social unrest, changes to monetary policy and a resurgence in trade tensions, the Fund added.
Asset and fund managers
There is a risk that “nonbank” financial companies — such as asset and fund managers — could also face shocks in the event of a broad wave of insolvencies. The IMF warned that these businesses could even act as an amplifier of this stress.
“For example, a substantial shock to asset prices could lead to further outflows from investment funds, which could, in turn, trigger fire sales from those fund managers that would exacerbate market pressures,” the Fund said.
The IMF estimated earlier this week that the global economy would contract by 4.9% this year, before growing at a pace of 5.4% in 2021. Both estimates were downgraded from April’s forecast.
Gita Gopinath, IMF Chief Economist and Director of the Research Department, speaks at a briefing during the IMF and World Bank Fall Meetings on October 15, 2019 in Washington, DC.
Olivier Douliery | AFP | Getty Images
“There is tremendous uncertainty,” Gita Gopinath, the IMF’s chief economist told CNBC’s Squawk on the Street Wednesday.
She added that “substantial support will need to be continued,” but its form will depend on how the recovery goes.
Governments and central banks around the world have launched large stimulus programs in an effort to keep economies afloat. In the euro zone, for instance, the European Central Bank is buying government bonds as part of a 1.35 trillion euros ($1.5 billion) emergency program to keep borrowing costs low for euro zone governments. Meanwhile,
The IMF also warned that corporate debt had risen over several years and currently stands at a “historically high level relative to GDP (gross domestic product).” This, coupled with household debt, which has also grown over the last years, is another vulnerability in the financial sector and could have a broader impact in the ongoing economic crisis.
“High levels of debt may become unmanageable for some borrowers, and the losses resulting from insolvencies could test bank resilience in some countries,” the IMF said.
Correction: The headline and text of this article was updated to more accurately reflect the stock market prediction from the IMF.