The International Monetary Fund or IMF warned that the disconnect between financial markets and the real economy bring about a correction in asset prices.
Latest data reveals a deeper-than-expected downturn, according to IMF. However, markets remain steady: the S&P 500 experienced 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 refers to a 10% or more fall in the price of an asset or index. IMF noted that valuations appear stretched across several 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.
The Fund explained that a shift in market sentiment could happen due to a second wave of coronavirus infections, changes to monetary policy, social unrest, and escalation in trade tensions.
Nonbank financial companies
"Nonbank” financial companies like asset and fund managers could encounter shocks amid a wide wave of insolvencies. The IMF noted that these businesses could amplify the 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.
“There is tremendous uncertainty,” Gita Gopinath, the IMF’s chief economist said during an interview with CNBC’s Squawk on the Street.
She pointed out that “substantial support will need to be continued,” but its form will depend on how the recovery goes.
The IMF also warned that corporate debt had increased over several years and currently shows a “historically high level relative to GDP (gross domestic product).” This, along with household debt, which has also increased over the last years, is a weakness in the financial sector and could further devastate 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.
Economic forecasts
IMF also reduced economic forecasts as the world suffers from the coronavirus crisis.
The organization warned that public finances may suffer heavily as governments try to fight the fallout from the health crisis.
The IMF predicts the economy will contract by 4.9% in global gross domestic product in 2020, lower than the 3% fall it predicted in April.
“The Covid-19 pandemic has had a more negative impact on activity in the first half of 2020 than anticipated, and the recovery is projected to be more gradual than previously forecast,” the IMF reported Wednesday in its World Economic Outlook update.
IMF also reduced its GDP forecast for 2021, predicting a growth rate of 5.4% from the 5.8% forecast made in April.
According to the fund, the downward revisions were caused by social distancing measures that may remain during the second half of the year. These measures have affected productivity and supply chains. IMF expects that longer lockdowns will hit economic activity even more.
The IMF warned that the economic predictions still face unprecedented uncertainty. Meanwhile, economic activity will be shaped by factors such as global supply chains, the length of the pandemic, social distancing, and new labor market dynamics.
