EU Economy - Most of the market segments affected by the turbulence following the UK referendum quickly recovered the bulk of their losses - The declines in euro area banks’ stock prices have been sizeable year-to-date as a result of shorter periods of sharp repricing. All in all, as risk premia at the global level remain compressed, more volatility in the near future is likely and the potential for an abrupt reversal remains significant .. - ECB

Publication - Financial Stability Review November 2016

Euro area systemic stress has remained relatively low over the past six months, despite bouts of market turbulence. 

Since mid-2013, both the volatility and the level of the euro area composite indicator of systemic stress have gradually edged upwards (see Box 1). The ratcheting-up of this indicator has been associated with a range of local and global stress events and has continued over the past six months. Factors that pushed it up include higher political uncertainty following the outcomes of the UK referendum on EU membership and the US election as well as market concerns about euro area banks’ longer-term profitability prospects. 

At the same time, continued accommodative monetary policy in advanced economies and abating market concerns about the possibility of a sharp slowdown in China have dampened spikes in systemic stress. All in all, despite relatively volatile global financial markets, bank and sovereign systemic stress indicators for the euro area have remained fairly stable at low levels (see Chart 1).

Mirroring developments in global markets, euro area asset prices have witnessed a number of sharp corrections in recent years. This pattern continued over the past six months, as demonstrated, in particular, by higher asset price volatility following the outcomes of the UK referendum and the US election (see Chart 2). Most of the market segments affected by the turbulence following the UK referendum quickly recovered the bulk of their losses, not least given a resolute policy response by the Bank of England. Market movements after the US election indicate a rotation from bonds to equities. Bond valuations declined by €1 trillion worldwide in the first week after the election, with European markets also being affected, albeit to a smaller degree than US markets. It is uncertain whether these developments will set a trend for the future.

 However, since the start of the year, corporate bond yields have remained at low levels, inter alia supported by ECB measures undertaken to combat low consumer price inflation. At the same time, euro area equity markets have remained volatile, particularly for cyclical sectors. The declines in euro area banks’ stock prices have been sizeable year-to-date as a result of shorter periods of sharp repricing. All in all, as risk premia at the global level remain compressed, more volatility in the near future is likely and the potential for an abrupt reversal remains significant amid heightened political uncertainty around the globe and underlying emerging market vulnerabilities. 

The euro area banking sector remains vulnerable, but proved to be resilient to recent market stress. Subdued economic growth and the associated low interest rate environment have dampened banking sector profitability prospects in the euro area and other advanced economies (see Chart 3). In the euro area, volatile stock market developments over the past six months contributed to an increase in banks’ cost of equity which may constrain banks’ ability to support the real economy via higher lending volumes. Furthermore, banks’ capacity to organically generate capital is constrained by low profitability prospects in a still subdued nominal growth environment. 

In October and early November, a steeper yield curve and growing market expectations that global bank regulation will end up less tight than previously expected contributed to an increase in bank stock prices. The main structural challenges for bank profitability continue to be related to the large stock of nonperforming loans in a number of countries, incomplete business model adjustments and overcapacity in some euro area banking sectors. Going forward, the higher cost of external financing coupled with the prospect of limited internal capital-generating capacity increase the likelihood that an adverse feedback loop could emerge between weak bank profitability and the sluggish economic recovery. 

Debt sustainability concerns remain for the sovereign and non-financial sectors. Euro area sovereign stress has remained contained amid the ongoing economic recovery, favourable sovereign financing conditions and the steady improvement in fiscal balances, but policy decisions at both the national and EU levels may lead to weakened fiscal and structural reform efforts. This, in turn, could weigh on both public finances and economic growth. 

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