The International Monetary Fund (IMF) has pointed to a disconnect between financial markets and the economic indicators and gone on to say that valuations appear stretched.
The stock markets have rallied in several countries as the economies were opened after the lockdown. IMF has sent a warning signal that this exuberance may be shortlived.
In its Global Financial Stability Report Update, IMF said financial conditions have eased but insolvencies loom large.
IMF said amid huge uncertainties, a disconnect between financial markets and the evolution of the real economy has emerged, a vulnerability that could pose a threat to the recovery should investor risk appetite fade.
It warned that 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.
“For example, in equity markets, bear market rallies have occurred before, during periods of significant economic pressure, often only to unwind subsequently. In corporate bond markets, spreads of investment-grade companies are currently relatively contained, contrary to the sharp widening experienced during previous significant economic shocks”, it said.
“In fact, market valuations appear stretched across many equity and corporate bond markets”, IMF report said. 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.
A number of triggers could result in a repricing of risk assets, a development that could add financial stress on top of an already unprecedented economic recession.
Flagging the risks, IMF said for example, the recession could be deeper and longer than currently anticipated by investors. There could be a second wave of the virus, and containment measures could be reinstated.
Market expectations about the extent and length of central banks’ support to financial markets may turn out to be too optimistic, leading investors to reassess their appetite for, and pricing of, risk. A resurgence of trade tensions could sour market sentiment,
putting the recovery at risk. Finally, a broadening of social unrest around the globe in response to rising economic inequality could lead to a reversal of investor sentiment.
The pandemic could crystallize other financial vulnerabilities that have built up over the past decade.
In advanced and emerging market economies alike, corporate and household debt burdens could become unmanageable for some borrowers in a severe economic contraction. As has been discussed in previous Global Financial Stability Reports, aggregate corporate debt has been rising over several years to stand at historically high levels relative to GDP.
Household debt has also increased, particularly in countries that managed to escape the worst impact of the 2007-8 global financial crisis. This means that there are now many economies with high levels of debt that are expected to face an extremely sharp economic slowdown.
This deterioration in economic fundamentals has already led to the highest pace of corporate bond defaults since the global financial crisis, and there is a risk of a broader impact on the solvency of companies and households.
IMF emphasized that insolvencies will test the resilience of the banking sector. Banks have entered the crisis with higher liquidity and capital buffers as a result of postcrisis reforms, and they can draw down these buffers to support lending and absorb losses.
Some banks have already started to provision more for expected losses on their loans, as evidenced in their first quarter earnings reports. This is likely to continue as banks assess the ability of borrowers to repay their loans, while also accounting for the support that governments have given households and companies. The expectation of
further pressure on banks, along with the low level of interest rates, is reflected in analysts’ forecasts of bank profitability, IMF said.