IMF warns a disconnect between financial markets and economies threatens a correction in risk assets

• A disconnect between financial markets and the real economy raises the risk of a correction in risk assets, the International Monetary Fund warned in its Global Financial Stability update Thursday.
• A correction is defined as a drop of at least 10% in the price of an asset.
• There are a number of triggers that could spark a sell-off in risk assets, which could "add financial stress on top of an already unprecedented economic recession," according to the report.
• Read more on Business Insider.

A disconnect looming between financial markets and economies means that risk assets such as stocks could be set up for a correction — a slump of more than 10% — according to the International Monetary Fund.

The S&P 500 has posted a swift rally from March lows even as US COVID-19 cases increased and the economy officially fell into a recession. The market's rapid recovery has been supported by "swift and bold actions by central banks," the IMF wrote in its June Global Financial Stability update released Thursday.

"This has created a divergence between the pricing of risk in financial markets and economic prospects, as investors are apparently betting on continued and unprecedented support by central banks," the IMF wrote. "This decoupling raises questions about the possible sustainability of the current equity market rally if not for the boost of sentiment provided by central bank support."

Going forward, there are a number of triggers that could spark a sell-off in risk assets, which could "add financial stress on top of an already unprecedented economic recession," according to the report. A second wave of coronavirus cases, additional lockdowns, and a resurgence of trade tensions all pose a risk to investor sentiment, the IMF said.

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In addition, the downturn may also be longer than investors are anticipating, or market expectations of continued central bank support may be too optimistic, said the IMF.

On Wednesday, the IMF again slashed its global economic forecast, seeing an even deeper downturn and longer recovery ahead from the shock of the coronavirus pandemic. The fund now sees global gross domestic product falling 4.9% in 2020, from the 3% decline it previously forecast in April.

The fund also warned that the pandemic could crystallize other financial vulnerabilities that have been growing in the last decade, including corporate and financial debts that could become "unmanageable for some borrowers in a severe economic contraction."