The October 2020 Global Financial Stability Report released by the International Monetary Fund (IMF) reveals that despite high economic uncertainty that arose with the spread of the COVID-19 pandemic, risk assets have already begun to experience recoveries.
The report issued indicates that even in the face of drops in economic activity and general pessimism about economic performance, global equity markets have picked up from the lows recorded earlier in the year in March. It, however, clarified that “markets rebounded on strong policy support, but with clear differentiation across countries and sectors” in growth depending on the extent of the virus’ spread in the country, the composition of its economic sectors as well as the policies enacted to mitigate the effects of the virus.
The report went on to detail stock market performance, stating that recoveries in the stock market had been largely boosted by policy support. A breakdown of the S&P 500 year-to-date performance, which took the contributions of both current and projected earnings, the risk-free rate, and the equity premium, revealed that a drastic reduction in the outlook of corporate earnings had a negative impact on stock market performance. Fortunately, this downward trend was compensated for by policy rate cuts and other policy measures such as a lower risk-free rate and the reduction of the equity risk premium, thus boosting risk sentiment.
“Falling risk-free rates and equity premium compression have supported equity market performance, despite the drag from a weaker earnings outlook.”
Additionally, participation of retail investors in the stock market has increased greatly in recent months and this may have also had a part to play in the recoveries being recorded by providing additional support to equity prices, the IMF opined.
“For example, in China, margin trading outstanding, which is often cited as an indicator of retail investors’ activities, has increased sharply since last year.”
The report however expressed concerns that the stock market rebound had gone too far, citing equity valuation models from the IMF which shows that overvaluations are at historically high levels in some countries.
According to the report, these equity price misalignments, that is the difference between the actual price and the model-based value, have been identified in significant differences between the high levels of economic uncertainty and the reductions in equity market volatility. The gap had been narrowed in the course of the sell-off that occurred in September, the IMF added.
“For example, both option-implied volatility (Chicago Board Options Exchange Volatility Index [VIX]) and realized market volatility have declined sharply in late March-April even though uncertainty about earnings outlook has remained elevated for some time.”
The IMF further asserted that these developments were a reflection of improvement in funding and liquidity conditions due to the implementation of various policy interventions even though uncertainty about earnings outlook have remained for some time. It also posited that these misalignments could have also been as a result of unintended outcomes of policies aimed at boosting investor sentiment and keeping markets open.
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