Markets rose despite subdued economic recovery: BIS Quarterly Review

• Financial markets gained despite a weak economic outlook and evidence of deteriorating credit quality.
• Monetary and fiscal policy underpinned high valuations, particularly in advanced economies.
• Concerns emerged about a disconnection between some risky asset classes and economic prospects.

Financial markets largely recovered from March's acute stress, according to the third BIS Quarterly Review¹ of 2020. This was supported by both monetary and fiscal policy, and investor sentiment arising from better than expected economic indicators in the initial aftermath of the lockdown phase of the pandemic.

However, the Review indicates that the economy's upturn has been uneven and corporate balance sheets remain fragile. The associated concern of stretched valuations being disconnected from underlying economic prospects, most notably in some segments of the equity and corporate credit markets, has since been reflected in the recent stock market sell-off.

Claudio Borio, Head of the BIS Monetary and Economic Department, said: "Based on a broad set of indicators, it is hard not to see a certain amount of daylight between risky asset prices and economic prospects, although recent moves in equities suggest growing investor sensitivity to the implications of the current environment for elevated valuations."

The report also outlines how the US dollar materially depreciated against advanced economy peers, particularly the euro, amid signs of more political and fiscal cohesion in the euro area. In parallel, the pandemic's geographical evolution seems to explain much of the weaker performance of emerging market economy (EME) currencies relative to the US dollar.

EME sovereign yields continued trending downwards, aided by their own supportive monetary policy, marking a significant departure from previous crises, when the prospect of currency meltdowns prompted rate increases. Declining advanced economy yields helped create monetary policy space for EMEs.

"The ultimate trajectory of financial markets will depend on the still uncertain course of the pandemic and its eventual impact on the real economy," said Hyun Song Shin, Economic Adviser and Head of Research.

The September 2020 issue of the BIS Quarterly Review

• Analyses how lower interest rates affect stock prices, deconstructing European and US equity benchmarks into short- and long-term components.
• Explores why equity investors have been negative towards banks, even though they entered the pandemic well positioned to absorb losses thanks to post-2008 regulatory reforms.

Four special features analyse developments in markets and the global economy:

• Iñaki Aldasoro, Wenqian Huang (BIS) and Esti Kemp (FSB) discuss vulnerabilities associated with cross-border linkages between banks and non-bank financial institutions, such as investment funds and central counterparties, paying particular attention to the financial market turmoil triggered by Covid-19. 
• Amanda Liu, Ilhyock Shim and Vladyslav Sushko (BIS) find that foreign investment vehicles dominate cross-border investment in Asia-Pacific commercial real estate markets, but their activity is volatile as they are sensitive to global financial conditions and yield differentials between commercial real estate and benchmark bonds. This can raise financial stability concerns. 
• Torsten Ehlers, Benoît Mojon and Frank Packer (BIS) analyse whether green bonds have significantly contributed to improving firms' carbon efficiency. They outline desirable features of rating systems for carbon emissions and suggest that providing ratings for firms themselves instead of just specifically for bond issues could complement existing labelling systems.
• Sirio Aramonte (BIS) examines how corporate share buybacks have tripled in the last decade, driven largely by a desire to meet particular leverage levels, which can be excessive if companies do not account for all financial distress costs.

¹ The period under review extends from 12 June to 7 September 2020.