The Monetary and Capital Markets Department of the International Monetary Fund (IMF) has intimated that various analysts and investors continue to raise concerns that the true value of risk assets like stocks and corporate bonds seems out of line with market value
The IMF further asserted that for instance, these market watchers point to the fact that there are “misalignments between (very high) equity market prices and valuations implied by (still weak) economic fundamentals, especially when considering the sizable economic uncertainties”.
Although Financial stability risks have been in check so far, the International Monetary Fund holds that this cannot be taken for granted. Action is needed to address vulnerabilities exposed by the pandemic.
“Prices for stocks, corporate bonds, and other risk assets have risen higher on the news of vaccine rollouts. Financial markets have shrugged off rising COVID-19 cases, betting that continued policy support will offset any bad economic news in the short term and provide a bridge to the future”.
Other market participants, however, note that current market valuations can be explained after accounting for the “lower-for-longer” interest-rate environment, the IMF added.
As justification for the equity market rally, these market participants also point to expectations of very low interest rates for the foreseeable future and to upward revisions in corporate earnings expectations since the vaccine announcements.
A low interest rate environment occurs when the risk-free rate of interest, typically set by a central bank, is lower than the historic average for a prolonged period of time.
Analysts have also hinted that this low interest rate environment helps to stimulate economic growth by making it cheaper to borrow money to finance investment in both physical and financial assets.
“The still relatively high volatility in equity markets as measured by…a barometer of market sentiment—which one could expect to be lower if investors were indeed exuberant”.
The IMF further posits that similar considerations about policy support have been made for credit markets.
Policy support remains crucial, according to the IMF. So, Policymakers should safeguard the progress made so far and build on the rollout of vaccines to return to sustainable growth by preserving monetary policy accommodation, ensuring liquidity support to households and firms, and keeping financial risks at bay.
“Policymakers need to use this time to safeguard financial stability by employing macroprudential measures…and developing new tools as needed”.
“Reducing or withdrawing support at this stage could jeopardize the global economic recovery,” IMF cautioned.
In conclusion, the IMF has warned that the surge of COVID-19 infections and the associated public health restrictions imposed by governments since late 2020 may hurt economic activity in many countries. Yet investors appear optimistic about growth prospects in 2021, confident that policymakers will backstop financial markets along the path to recovery.
“While there is for now no alternative to continued monetary policy support, there are legitimate concerns around excessive risk-taking and market exuberance.
“As the apparent disconnect between exuberant financial markets and the still-lagging economic recovery persists, it raises the specter of a possible market correction should investors reassess the economic outlook or the extent and duration of policy backstop”.