June 1, 2023: On Wednesday, Monetary businesses could meet an intense downturn in the event of further shocks to the global economy, European Central Bank Vice-President Luis de Guindos said.
Earlier on Wednesday, the ECB published its May Financial Stability Review, saying that the euro area’s stability outlook remained fragile after the recent turmoil in the banking sector, which saw several U.S. regional banks’ failure and UBS’s emergency takeover of Credit Suisse.
Although it determined that bank resilience in a higher interest rate environment was not a concern in the eurozone, with fundamentals remaining solid and regulatory intervention proving effective, the ECB said it is “possible that these events could lead to a reassessment of the profitability and liquidity outlooks for euro area banks.”
The ECB highlighted that global stock markets made a robust start to 2023, given falling energy prices, China’s reopening, and the surprising resilience of the eurozone economy, driving equity valuations back above historical averages.
This reversed abruptly in previous February and March as a hawkish tone from major banks and unexpected stress in the banking sector roiled investors around the world. De Guindos said current market positioning remade stocks vulnerable to other macro surprises.
“There is the possibility of a correction in needs, and the reason is that valuations are high, are elevated, and if you look at, for instance, risk premia, they are quite close, so just in case we have bad news concerning the macroeconomic outlook, that could give rise to a correction of markets,” de Guindos expressed.
The ECB report noted that the potential for “disorderly adjustments” in financial markets had spiked against tighter economic conditions and lower market liquidity. The central bank said that the banking sector turmoil of March led to a widening of credit risk premia in the euro area.
“By contrast, the fact that equity risk premia remain compressed in absolute and relative terms, especially in the United States, raises concerns over potential overvaluation. Equities may thus be more vulnerable to a disorderly price correction in the event of a further deterioration in the economic outlook,” the report said.
“As such, risk sentiment remains fragile and is highly sensitive to surprises as regards the outlook for inflation, growth, and monetary policy in mature economies.”
This could result in more persistent inflationary pressures, forcing central banks into “more significant” policy tightening than the markets have currently priced in.
There are also risks to the banking system from any fragility in non-bank financial institutions, de Guindos highlighted.
“We indicate that interlinkages are relevant and are important so that you cannot immunize what happens in the banking industry from the non-banking industry.”