After the U.S. stock market cratered 34% due to the pandemic in March, stocks have rebounded strongly despite negative news. The disconnect between stock prices and the economy has never been that high. But this disconnect could soon go away.
The International Monetary Fund (IMF) has warned that the current disconnect between financial markets and the real economy could lead to a correction in asset prices. A correction is defined as a drop of 10% or more in the price of an asset or index.
The IMF expects the recovery to be more gradual than previously forecast. It is now projecting a deeper recession in 2020 and a slower recovery in 2021.
The IMF projects global output to contract 4.9% in 2020, before growing by 5.4% in 2021. The world is facing an uneven and uncertain recovery.
Despite adverse economic news, the S&P 500 had its biggest 50-day rally in history in early June.
The disconnect between markets and the real economy increases the risk of a further correction in stocks should investors’ appetite fade. The stock market hasn’t been that expensive since the dot-com bubble.
According to IMF models, the difference between market prices and fundamental valuations is close to historic highs in most major advanced equity and bond markets.
A second wave of infections, further social unrest, monetary policy changes, and a resurgence in trade tensions could trigger a shift in market sentiment.
The IMF also warned that corporate debt has increased over several years and is currently at a “historically high level relative to GDP.”
This, coupled with surging household debt, adds another layer of vulnerability to the financial sector.
Airlines, cruise lines, and hotel stocks surged in early June when investors were optimistic about the U.S. reopening. But the rally in those reopening trades has faded as the road to recovery is bumpy.
Americans thought that when the country would reopen, things could only get better.
The market was priced for a continuation of improvement and I think that’s overstating what’s going to happen. We are going to have episodes of cases rising. We are going to have a very slow and uneven improvement in the jobs market.
The data begin to give a read on the shape of the recovery. It’s becoming clear that it won’t be V-shaped. The economy is going to need more help to bounce back.
While the slowdown in virus cases played a big part in the market rally, unprecedented Fed’s stimulus was a crucial factor in pushing stock prices higher.
But the Fed’s support alone isn’t enough to calm down investors’ fears.
Lindsey Bell, chief investment strategist at Ally Invest , said in a note:
The Fed can’t prevent the volatility we’re seeing in stocks. It will likely take years for the economy to fully recover and there remain other uncertainties on the path ahead.
The release of a vaccine or treatment and additional policy support could help the economy to recover quicker.
But in the meantime, the disconnect between stock prices and the economy will likely lead to a correction. The rally will not go on forever.