De Guindos of the European Central Bank warns that financial markets are vulnerable to a sell-off

European Central Bank Vice President Luis de Guindos told CNBC on Wednesday that financial markets could face a sharp slowdown in the event of any further shocks to the global economy.

Earlier on Wednesday, the European Central Bank published its May Financial Stability Report, saying that the outlook for stability in the eurozone remained fragile in the wake of recent turmoil in the banking sector, which saw the failure of several US regional banks and the emergency takeover of Credit Suisse by UBI. s.

Although it determined that banks’ resilience in a rising interest rate environment was not a concern in the eurozone, with fundamentals remaining strong and regulatory intervention proving effective, the ECB said that “these events could lead to a reassessment of the profitability and liquidity outlook of banks”. Euro-zone “.

The European Central Bank has made it clear that global equity markets have had a strong start to 2023, given lower energy prices, China’s reopening, and the surprising resilience of the eurozone economy — pushing stock valuations above historical averages.

This abruptly reversed in late February and March as a hawkish tone from central banks and unexpected pressures in the banking sector unnerved investors around the world. De Guindos said the current market situation made the stock vulnerable to further macro surprises.

“There is potential for a correction in the markets, and the reason is that valuations are high, they are up, and if you look at, say, the risk premium, they’re quite compressed, so just in case there’s bad news with the macro outlook, it could lead to a correction. markets.”

The ECB report indicated that the potential for “disorderly adjustments” in financial markets has risen on the back of tighter financial conditions and lower market liquidity. The central bank said the banking sector turmoil in March led to a widening of credit risk premiums in the eurozone.

By contrast, the fact that equity risk premiums remain compressed in both absolute and relative terms, particularly in the US, raises concerns about possible overvaluation. Equities may thus be more vulnerable to a disorderly price correction in the event of a further deterioration. in economic forecasts.

As such, risk sentiment remains fragile and highly sensitive to surprises regarding the outlook for inflation, growth and monetary policy in mature economies.

This could take the form of more persistent inflationary pressures, forcing central banks to tighten policy “more significantly” than the ones markets are currently priced at.

De Guindos explained that there are also risks to the banking system from any fragility in non-bank financial institutions.

“We point out that interconnections are so relevant and important that you can’t immunize what’s happening in the banking industry from the non-banking industry.”

The ECB report stated that although the non-bank financial sector remains resilient for the time being, exposure to credit risk remains high, opening up “risks of material loss should corporate sector fundamentals deteriorate significantly”.

She added, “In addition, the exposure of non-banks to the real estate markets has increased significantly in recent years, making institutions vulnerable to the continuous correction of real estate prices.”

“Strong links with banks, as an important source of financing for example, can also create additional vulnerabilities in the banking sector through liquidity and credit risk repercussions.”