EDITOR NOTE: There was a time, not so long ago, when the claim that central banks were the chief engineers of booms and busts would’ve been dismissed as conspiracy theory. After all, the economy is driven by business activity, not the Fed, right? Well, if that’s the case, mainstream investors have confirmed the contrary, as they’ve pinned their hopes on the Fed in the face of job losses, business insolvencies, and the rapid spread of COVID-19. The IMF sees this strange disconnect and has been warning investors ever since. But will the markets listen?
Has the stock market ever seemed so disconnected from reality?
Global share prices have been racing higher ever since the start of Covid-19-related shutdowns in mid-March, mostly on hopes of ever-increasing amounts of fiscal and monetary stimulus.
“Investors seem to be betting that lasting strong support from central banks will sustain a quick recovery even as economic data point to a deeper-than-expected downturn,” write senior International Monetary Fund officials Tobias Adrian and Fabio Natalucci in a new blog.
The economists argue that recent market stability may just represent a period of calm ahead of stormier waters as the compounding negative economic effects of job losses, reduced spending and business closures weighs on the outlook.
“Debt levels are rising, and potential credit losses resulting from insolvencies could test bank resilience in some countries,” wrote Adrian and Natalucci. “Some emerging market and frontier economies are facing refinancing risks, and lower-rated countries have started to regain access to markets only slowly.”
So, what could possibly go wrong?
“This divergence raises the specter of another correction in risk asset prices should investors’ attitude change, posing a threat to the recovery,” the blog says. “So-called bear equity market rallies have occurred in the past during periods of significant economic pressures, only to unwind swiftly.”
And what might trigger such a reversal of fortunes for bullish investors? Quite a few things:
“The recession could be deeper and longer than currently anticipated by investors,” posit Adrian and Natalucci.
“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,” they write.
In addition, “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.”
Originally posted on Forbes