US stock markets which have rallied during the AI boom are at risk of a “sudden, sharp correction” while government bond markets are under mounting pressure, the International Monetary Fund has warned.
In its Global Financial Stability Report, published as policymakers gather in Washington for the IMF’s annual meetings, the Fund said that markets appear “complacent”.
It highlighted “increasing vulnerabilities in the financial system,” including in stock and bond markets, and among “non-bank financial intermediaries” (NBFIs) or “shadow banks”, which it warned are now closely bound to the banking sector.
US stock markets have repeatedly roared to record highs in recent months. The IMF said stocks do not appear as overvalued as they did during the dotcom bubble at the turn of the millennium. But it said the gains are worryingly concentrated among the “magnificent seven” tech firms, which include Apple, Nvidia and Meta.
“Concentration risk within the S&P 500 is at a historic high, with a narrow group of stocks spanning mega-cap IT and AI-related firms driving the broader index,” it said, adding that the magnificent seven account for 33% of the index.
It warned “the possibility of mega-cap stocks failing to generate expected returns to justify current lofty equity valuations could trigger deterioration in investor sentiment and make the stocks susceptible to sudden, sharp correction,” adding, “valuations would collapse as a result, making the broader benchmark index vulnerable to downturns.”
The Fund also expressed concern about the stability of government bond markets, with many countries expanding borrowing significantly, and increasingly dependent on “price-sensitive investors”, rather than domestic pension funds, for example.
Analysing recent trends in these markets, including shifts in yields, which move inversely to prices, the IMF suggested they may be “on shakier footing than they seem”.
The IMF said stress in the markets for leading governments’ bonds remains unlikely – a “tail risk” – but would have “broad and disruptive ramifications for financial markets, given bonds’ role as key benchmarks and collateral”.
The Fund renewed its warnings about the burgeoning growth of NBFIs in the global economy. These lenders, which face less onerous capital requirements than traditional banks, have expanded rapidly in recent years. The IMF pointed to the fact that mainstream banks are increasingly lending to NBFIs, raising the risks of a systemic crisis if they began to struggle.
“Banks’ growing exposures to NBFIs mean that adverse developments at these institutions – such as downgrades or falling collateral values – could significantly affect banks’ capital ratios,” the IMF said. It added that the sector should be better regulated: “The growing importance of NBFIs in financial intermediation highlights the need for sound oversight of this segment.”
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It said these vulnerabilities made it all the more important to press ahead with implementing new bank capital rules meant to forestall a future crisis – the Basel III regime. The US has not done so, prompting the Bank of England to delay it, too.
In a sideswipe at the Donald Trump, the IMF also urged governments to resist interfering with interest rate policy, saying “central bank operational independence remains critical for anchoring inflation expectations and enabling central banks to achieve their mandates.”
Trump has sought to remove the Federal Reserve governor, Lisa Cook, and repeatedly attacked the Fed chair, Jay Powell, for failing to cut interest rates as rapidly as the White House would like.
In another comment, couched in terms of the “G4” leading bond issuers – the US, the UK, Japan and the eurozone – but apparently aimed at Washington, the IMF added, “sustained trust in the institutional foundations in G4 economies has underpinned their sovereign bonds’ safe-asset status for decades and needs to be preserved.”
