Financial markets' disconnect from real economy may lead to corrections, IMF says

Despite a global economic decline, equity market valuations imply a strong recovery

Gita Gopinath, chief economist of the IMF, says there is divergence between financial market indicators and the real economic activity. AFP

There is a “striking divergence” between financial markets and the real economy, which could lead to greater volatility and sharp corrections, the International Monetary Fund said.

Financial market indicators point to stronger prospects of a recovery in global output than what activity in the pandemic-hit real economy suggests, Gita Gopinath, the fund’s chief economist, said on Tuesday.

“This divergence may portend greater volatility in financial markets,” she said in a blog post. “Worse health and economic news can lead to sharp corrections.”

The S&P 500 has recouped most of its losses since the start of the crisis, despite an economic collapse in the US and the Federal Reserve’s forecast of a 6.5 per cent fall in gross domestic product this year.

Ms Gopinath said the Africa and FTSE Russell emerging market indexes have improved substantially while the Bovespa, Brazil’s benchmark equities index, has risen significantly despite the recent surge in Covid-19 infection rates in the country.

The increase in sovereign debt spreads and the depreciation of emerging market currencies are also smaller than what was experienced during the global financial crisis, with a few exceptions.

“This is notable considering the larger scale of the shock to emerging markets during the ‘Great Lockdown’,” Ms Gopinath said.

Portfolio flows to emerging and developing economies have also stabilised, despite the economic upheaval in these economies.

The virus has infected about 8.05 million people worldwide and killed more than 437,000, according to Johns Hopkins University, which is tracking the outbreak.

The pandemic forced governments to close borders and shut all but essential businesses to stem the spread of the virus, which brought economic activity to a standstill. Countries started to gradually reopen their economies last month in adherence with World Health Organisation guidelines.

Earlier this month, the Organisation for Economic Cooperation and Development said global output is projected to contract by 7.6 per cent this year in the absence of a vaccine, while unemployment in some of the world’s largest economies could more than double to about 11 per cent.

The World Bank expects global output to shrink by 5.2 per cent, while the IMF said on Monday that it expects to cut its April forecast of a 3 per cent contraction when it releases its latest projections on June 24.

The fund’s managing director Kristalina Georgieva said last week that about 170 countries will be left worse off by the pandemic, with lower per capita income by the end of this year despite an injection of about $10 trillion (Dh36.7tn) by governments and central banks to stabilise the world economy.

As more economies reopen four months after the WHO declared Covid-19 a pandemic, the rate of infection continues to rise in some emerging market and developing countries. The infection rate in some US states has increased and China, the world’s second largest economy, is battling a new outbreak of Covid-19 in Beijing.

Despite the second wave of infections and prospects of a worsening economic outlook, equity markets have generally rallied in recent weeks, with the S&P500 index climbing 37 per cent from its lowest close this year on March 23.

The most probable factor behind this divergence is the stronger policy response to the crisis, Ms Gopinath said.

“Monetary policy has become accommodative across the board, with unprecedented support from major central banks and monetary easing in emerging markets, including through first-time use of unconventional policies,” she said.

The pandemic has also dealt a “uniquely large blow” to the global services sector, hitting it harder than manufacturing.

“This time is different. In the peak months of the lockdown the contraction in services has been even larger than in manufacturing, and it is seen in advanced and emerging market economies alike,” Ms Gopinath said.

“It is possible that with pent-up consumer demand, there will be a quicker rebound, unlike after previous crises. However, this is not guaranteed in a health crisis as consumers may change spending behaviour to minimise social interaction.”

A significant challenge will be around the adequate production and distribution of vaccines and treatments when they become available, and this will require a global effort.

“As the recovery progresses, policies should support the reallocation of workers from shrinking sectors to sectors with stronger prospects,” Ms Gopinath said.