A day after it slashed its global growth forecasts for 2020, led by a big slicing of the US estimate, the International Monetary Fund has cautioned financial markets about being too exuberant and getting too far in front of economic reality.
In a report on an IMF blog, the heads of the funds monetary and capital markets say a “disconnect” between financial markets and economic prospects has emerged.
The report, by Tobias Adrian, Director of the IMF’s Monetary and Capital Markets Department and Fabio Natalucci, a deputy director in the department points out that market valuations are becoming ‘stretched’, which in turn will pose a threat to the global economic recovery if investors’ risk-appetite fades.
This could become critical if the coronavirus spreads more widely (as it is doing now), if lockdowns are reimposed (not yet) or trade tensions surge again perhaps in the run up to the November3 polls in the US.
Sharemarkets slumped earlier this year as the virus and related lockdowns undermined but they have broadly rallied from their March 23 low. The S&P, which fell 34% in just 23 trading days, has been boosted by central bank support that emerged as the virus was whacking demand and markets. The S&P has rebounded (and Nasdaq is now at new highs) and is now around 10% under the highs of February.
“The disconnect between financial markets and the real economy can be illustrated by the recent decoupling between the soaring US equity markets and plunging consumer confidence (two indicators that have historically trended together), raising questions about the rally’s sustainability if not for the boost provided by central banks,” the report said.
“This divergence raises the spectre of another correction in risk asset prices should investors’ attitude change, posing a threat to the recovery. So-called bear equity market rallies have occurred in the past during periods of significant economic pressures, only to unwind swiftly.”
“Debt levels are rising, and potential credit losses resulting from insolvencies could test bank resilience in some countries.”
A correction could be prompted by a deeper and longer recession than currently anticipated, a second wave of the virus or reinstated containment methods. A broadening of global social unrest in response to rising economic inequality could also damage investor sentiment, the IMF said.
“We worry about scarring in the economy, meaning the crisis might be longer than expected and deeper than expected,” said Adrian. “Scarring is due to the high level of unemployment and the potential for insolvency. These are difficult to reverse.”
The report should have also mentioned the growing political uncertainty in the US and the way it is now undermining attempts to control the spread of the virus – those efforts are failing judging by the rapid re-emergence of infections in California, Alabama, Texas, Arizona, the Carolinas and other states in the south and southwest (most of whom strongly support Trump and the Republicans).
That’s possibly the biggest threat to US markets (and through that, the rest of the world).
