Real economy, financial markets in tug-of-war

A tug of war between the real economy and financial markets — and the risks involved could lead to a correction in asset prices.

According to the latest IMF’s Global Financial Stability update, with huge uncertainties about economic outlook and investors highly sensitive to COVID-19 developments, pre-existing financial vulnerabilities are being exposed by the pandemic.

It warns that debt levels are increasing — and potential credit losses resulting from insolvencies could test bank resilience in some countries.

The report says some emerging market and frontier economies are facing refinancing risks, and lower-rated countries have started to regain access to markets only slowly.

This disconnect between financial 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.

So-called bear equity market rallies have occurred in the past during periods of significant economic pressures, only to unwind swiftly.

It suggests that a number of developments could trigger a decline in risk assets’ prices.

It also advises that the recession could be deeper and longer than currently anticipated by investors. There could be a second wave of infections, with ensuing containment measures.
Geopolitical tensions or broadening social unrest in response to rising global inequality could lead to a reversal in investor sentiment.

However, expectations about the extent of central banks’ support could turn out to be too optimistic, leading investors to reassess their appetite and pricing of risk.

“Such a re-pricing, especially if amplified by financial vulnerabilities, could result in a sharp tightening in financial conditions, thus constraining the flow of credit to the economy. Financial stress could worsen an already unprecedented economic recession, making a recovery even more challenging,” reads part of the IMF report.

Gita Gopinath, IMF’s chief economist, said household debt has also increased in many economies, some of which now face an extremely sharp economic slowdown.

The deterioration in economic fundamentals has already led to a corporate ratings downgrade, and there is a risk of a broader impact on the solvency of companies and households.

The IMF said the realisation of credit events will test the resilience of the banking sector as they assess how governments’ support for households and firms translates into borrowers repaying their loans.

Some banks have started to prepare for this process, and expectation of further pressure on their profitability is reflected in the declining prices of their stocks.

Gopinath noted that nonbank financial companies could also be affected. These entities now play a greater role in the financial system than before.

But since their appetite for continuing to provide credit during a deep downturn is untested, they could end up being an amplifier of stress. For example, a sharp correction in asset prices could lead to large outflows in investment funds.

She stated that while conditions have eased in general, risks remain for some emerging and frontier markets that face more urgent refinancing needs. Their debts’ rollover will be more costly should financial conditions suddenly tighten. Some of these countries also have low levels of reserves, making it harder to manage portfolio outflows. Credit-rating downgrades could worsen this dynamic.

She urged that countries need to strike the right balance between competing priorities in their response to the pandemic, being mindful of the trade-offs and implications of continuing to support the economy while preserving financial stability.

The IMF pointed out that the unprecedented use of unconventional tools has undoubtedly cushioned the pandemic’s blow to the global economy and lessened the immediate danger to the global financial system—the intended objective of policy actions.

However, policymakers need to be attentive to possible unintended consequences, such as a continued build-up of financial vulnerabilities in an environment of easy financial conditions.

The expectation of continued support from central banks could turn already stretched asset valuations into vulnerabilities—particularly in a context of financial systems and corporate sectors that are depleting their buffers during the pandemic.
Once the recovery is underway, policymakers should urgently address vulnerabilities that could sow the seeds of future problems and put growth at risk down the road.