Growing uncertainty about global economic growth could lead to “bouts of high volatility” in financial markets, the European Central Bank (ECB) warned Wednesday.
In its Financial Stability Review (FSR), which provides an appraisal of potential risks to stability in the euro area, the ECB cautioned that weaker-than-expected growth and a possible escalation of trade tensions could trigger further falls in asset prices.
Global stocks have gone through periods of heavy selling on the back of an escalating trade war between the U.S. and China. The Dow Jones Industrial Average index and the S&P are down more than 4.6% and 4% respectively since the start of this month. Meanwhile, the pan-European Stoxx 600 is down 5.2% for the month of May.
“If downside risks to the growth outlook were to materialize, risks to financial stability may arise,” said Luis de Guindos, vice president of the ECB, in statement Wednesday.
“The growth outlook is central to all the main risks to financial stability.”
In March, the euro zone’s central bank slashed its growth forecast for 2019 to 1.1% from an earlier forecast of 1.7% made in December 2018. ECB President Mario Draghi said at the time that there had been a “sizable moderation in economic expansion that will extend into the current year.”
Leveraged loans
The report on Wednesday identified the growing global leveraged loan sector as particularly susceptible to weaker corporate earnings. Leveraged loans are the type of loan that is extended to companies or individuals that already have considerable amounts of debt and/or a poor credit history. U.S. leveraged loans recently became a $1 trillion market, according to S&P.
The ECB further warned that banks will continue to struggle with profitability remaining low in the euro area. The ECB estimates suggest that a significant portion of European banks will miss expected returns of around 8-10% required by investors.
Though overall capital requirement in banks remains strong, the FSR calls on banks to tackle a number of structural challenges in order to return to profitability. Banks in Europe have struggled with weak earnings growth in the last few years due to a low interest rate environment, uncertainty around the U.K.’s exit from the European Union and in some cases massive fines for their involvement in the 2008 financial crisis.
Property warning
Higher risk-taking in the investment fund sector was also flagged in the report, and the FSR cautioned that a sudden repricing of financial assets could mean investors withdraw their money from funds, which would lead to forced asset sales and amplify stress in less liquid markets.
The ECB also warned that real estate prices could correct if the downside risks to growth were to materialize. House prices in the euro area grew by 4.2% in 2018, which the report said contributed to “signs of mild overvaluation for the euro area as a whole.