World — Disconnect between Main and Wall Street threatens recovery
World Risk Developments July 2020
The IMF warns that surging financial market optimism, predicated on continued unprecedented stimulus from central banks, poses a threat to the recovery should investors’ risk appetite fade. After sharp declines in February and March, share prices have rallied dramatically; for example, the S&P 500 recently erased all its losses for the year, but the markets remain volatile. The IMF warns that market valuations now appear stretched; the gap between prices and fundamentals in equity and corporate bond markets are near historic highs across most major advanced economies.
According to the IMF, the catalyst for renewed investor optimism was exceptional central bank efforts to backstop economies. G10 central bank balance sheets have swelled by US$6 trillion (15% of G10 GDP) since mid-January, more than double the increase seen during the 2008-09 GFC. This owes to new rounds of asset purchases, US dollar swap lines and credit and liquidity facilities. In particular, the US Federal Reserve has bought record amounts of corporate debt, including high yield ‘junk’ bonds, to secure the cashflow of America Inc.
However, stock market exuberance is at odds with much of life on Main Street. This contrast is illustrated by the decoupling of US equity markets and consumer confidence, which have historically trended together (Chart). A rapid reversal of investor sentiment could be triggered by a myriad of risks. For instance, a second wave of infections, a resurgence of trade tensions, a broadening of social unrest amid rising inequality, or crystallisation of pre-existing financial vulnerabilities. Global debt topped a record 331% of GDP (US$258 trillion) in Q1, but corporate and household debt burdens could become unmanageable in a severe economic recession, testing the resilience of banks. Already, non-financial corporate bond defaults jumped to a record US$94 billion in Q2. Several emerging markets are also facing refinancing risks, where some US$620 billion in foreign currency debt comes due this year. A swift repricing of risk could constrain the flow of credit to the economy, thereby frustrating an eventual recovery.