A prolonged COVID-19 pandemic could lead to a sharp correction in the stock market, IMF warns

• Should the COVID-19 pandemic continue for longer than expected, the economic consequences will likely lead to a sharp correction in global stocks, the IMF warned on Tuesday.
• Extraordinary policy measures from governments around the world helped stem the decline in stocks since the initial February decline, but underlying economic conditions remain weak and the future outlook is highly uncertain, the IMF said.
• Investor worry over a potential prolonged COVID-19 pandemic could have been heightened on Tuesday after Johnson & Johnson paused its phase III vaccine trial due to an unexpected illness.
• As long as investor optimism over easy fiscal and monetary policy continues, stocks can stay elevated for some time, but a significantly delayed economic recovery due to the persistence of COVID-19 could put a serious dent in that optimism, according to the IMF.
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The COVID-19 pandemic and its associated economic decline led to a sizable stock market correction that was stabilized thanks to extraordinary fiscal and monetary policy measures from governments around the world.

But there's a real financial disconnect between the stock market and the economy, and while the disconnect could narrow if a swift and sustainable economic recovery materializes, the opposite could happen if the economic recovery is delayed due to it taking longer to get COVID-19 under control, the IMF warned on Tuesday.

"As long as investors believe that markets will continue to benefit from policy support, asset valuations may stay elevated for some time. Nonetheless, and especially if the economic recovery is delayed, there is a risk of a sharp adjustment in asset prices or periodic bouts of volatility," the IMF said.

Easy monetary policies like low interest rates and the buying of distressed assets, combined with fiscal stimulus, helped maintain the flow of credit to the economy during the height of the COVID-19 pandemic.

And while these policies prevented a seize in the financial markets and helped hasten an economic recovery, there are still knock-on effects that investors should closely monitor, according to the IMF.

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"Corporate sector vulnerabilities are high and rising."

A surge in corporate debt to help stem the economic impact of COVID-19 only added to an already record-high amount of corporate debt, the IMF highlighted. Companies taking on more debt no doubt helped stem a wave of bankruptcies, but those bankruptcies may only have been delayed, not fully prevented.

"This means that solvency risks may have shifted into the future and renewed liquidity pressures could easily morph into insolvencies, especially if the recovery is delayed," the IMF said.

"Banks' resilience will be tested."

Regulations on banks after the Great Recession helped prepare them for today's economic crises, allowing them to be part of the solution rather than the problem by extending credit to households and businesses.

But according to an analysis by the IMF, in a declining economy, "some banking systems may suffer significant capital shortfalls because a large number of firms and households will not be able to repay their loans."

To prevent a prolonged economic decline, possibly due to a prolonged COVID-19 pandemic, the IMF advocates for a number of policy recommendations.

Governments and central banks should maintain accommodative policies to help sustain the recovery, and continue to support credit markets to maintain liquidity, "even if its pricing should be gradually adjusted to incentivize the return to normal market funding," the IMF said.

Once the pandemic is under control, "a robust financial reform agenda could focus on rebuilding bank capital buffers, strengthening the regulatory framework for nonbank financial institutions, and on stepping up prudential supervision to contain excessive risk-taking in a 'lower for longer' interest-rate environment," the IMF concluded.

Investor worry over a potential prolonged COVID-19 pandemic could have been heightened on Tuesday after Johnson & Johnson paused its phase III vaccine trial due to an unexpected illness.

Read more: Morgan Stanley lays out its 5 favorite trades for investors looking to dominate a looming V-shaped recovery, even if a stimulus deal takes until 2021