The IMF warns of a disorderly correction in global financial markets

Dangerously High Valuations Amid Multiple Uncertainties

According to the valuation models presented by the IMF, the prices of risky assets are largely above their economic fundamentals. This situation mechanically increases the likelihood of disorderly corrections in the event of adverse shocks. The institution notes that « beneath a calm surface, the ground is shifting » in several segments of the financial system, revealing worrying vulnerabilities.

Equity and corporate credit valuations remain particularly strained, driven by investor enthusiasm for technology stocks related to artificial intelligence. This focus on a limited number of companies has reached a historic level, creating a risk of sudden and sharp correction if expected returns do not justify these high valuations.

The IMF highlights that US stock prices, relative to anticipated earnings, are near the top of the range observed since 1990, even though they remain slightly below the levels of the early 2000s dot-com bubble. However, the key difference lies in the current extreme market concentration, with a narrow group of megacap information technology and AI companies driving the entire index. Disappointment in earnings or productivity gains related to artificial intelligence could trigger a sharp reevaluation, marking the end of the investment boom and the accompanying exuberance.

Financial markets have indeed shown notable resilience since April, the start of the US trade war, supported by expectations of monetary easing in major advanced economies. But this optimism conceals potential damage linked to tariffs and the high level of public debt. Investors seem overly complacent in the face of the structural challenges of the global economy, resulting in assets being traded at levels that increase the risk of an abrupt correction.

The Non-Banking Financial Sector: A Source of Amplified Systemic Risks

The IMF pays particular attention to the non-bank financial sector, which includes insurance companies, pension funds, investment funds, and hedge funds. These institutions, which do not take deposits but play an increasing role in global markets, now hold about half of the world's financial assets. Their regulatory treatment remains highly varied, with specific supervisory frameworks for insurers, but much less robust prudential oversight for many other entities.

Stress tests conducted by the IMF highlight that vulnerabilities within these non-bank entities can quickly spread to the core banking system, magnifying shocks and complicating crisis management. In the United States as well as in the eurozone, many banks have exposures to the non-bank sector that exceed their high-quality capital, which is meant to absorb losses during periods of stress. This growing interconnection between banks and less regulated financial players acts as an amplifier in case of shocks originating from areas such as private credit, real estate, or cryptocurrencies.

Non-bank institutions now also account for half of the daily transactions in the foreign exchange market, more than double their share from twenty-five years ago. While this evolution has certainly facilitated capital market activities and expanded risk diversification opportunities, it has also introduced increased complexity and interconnections, making the system more susceptible to periods of tension.
The IMF emphasizes that the vulnerabilities of the non-bank sector are interconnected and can rapidly spread to the traditional banking system. This year's stress test models a stagflation shock combining recession, rising inflation, and increasing yields on sovereign debt. It finds that about 18% of banks, by the volume of global assets, would see their core capital ratios drop below the 7% threshold. Although these results show an improvement compared to previous assessments, they reveal the presence of a subset of fragile banks within the global financial system.

Urgent Recommendations to Safeguard System Stability

Facing these multiple risks, the IMF has issued a set of recommendations for policymakers. The institution first calls on central banks to remain vigilant against inflationary risks induced by tariffs and to adopt a cautious approach to monetary easing. In jurisdictions where inflation remains significantly above targets and tariffs could pose a supply shock, central banks should exercise caution with any easing and remain committed to their price stability mandates.

This measured approach should also help limit further pressure on risky asset valuations. The IMF particularly emphasizes the operational independence of central banks, deemed essential for anchoring market expectations and enabling these institutions to fulfill their mandate.

This warning takes on particular significance as Donald Trump's repeated attacks on Federal Reserve officials emerge as the greatest threat to central bank independence in decades. On the fiscal front, the international institution calls for urgent adjustments to contain deficits and ensure the resilience of bond markets. The analysis of sovereign debt markets reveals increasing pressure on their functioning due to the widening fiscal deficits.

Although these markets have remained generally stable so far, sharp rises in yields could weaken bank balance sheets and put pressure on open-ended funds like mutual funds. Stress in key bond markets, even as an extreme risk, could have broad and disruptive implications for financial markets given the critical role of these bonds as benchmarks and securities.

Regarding the non-banking sector, the IMF advocates for strengthened supervision and progress on internationally agreed prudential standards, particularly the Basel III agreement. This also includes improving data quality, enhancing domestic and cross-border coordination, and demonstrating regulatory innovation to keep pace with sector developments.

The institution finally calls for effective regulation of stablecoins and strengthening of financial safety nets to preserve global financial stability amid increased economic uncertainty.