Downside risks on the rise, European regulators say

Securities markets remain sensitive to potential deterioration in economic fundamentals and financial-sector risks, says a new report from the European Securities and Markets Authority (ESMA) on Thursday.

In its second report this year on risks and vulnerabilities, ESMA said markets are adapting to higher inflation and interest rates, as reflected in the market’s rebound in the first half of 2023.

Downside risks, however, have increased.

Despite the market rebound, “the economic outlook remains fragile and uncertainties continue to drive markets,” said ESMA chair Verena Ross in a release. “There is a high risk of corrections in a context of fragile market liquidity in equity and bond markets, with short-term risks for consumers due to volatility and the impact of inflation on real investment returns.”

The report outlined such concerns as the sustainability of private and public debt amid higher interest rates. Increasing high-yield defaults, for example, are an early sign of quality deterioration within corporate debt. The proportion of high-yield ratings that defaulted rose to 0.76% in the first half of 2023 from 0.53% in the second half of 2022, and 0.19% in the first half of 2022, the report said.

Within asset management, real portfolio returns continue to be affected by a weak economic outlook and inflation. Fund risk remains high due to prevailing credit, valuation, liquidity and interest rate risks, the report said. The risk is especially acute for funds that combine several vulnerabilities, such as in the real estate fund sector, it said.

For consumers, risks include market volatility and high inflation, aggressive marketing, and poor cost disclosure.

The report also highlighted issues within financial innovation, such as valuations and liquidity related to cryptoassets. Further, “persistently elevated cyber risks remain an important source of concern for the [European Union] financial sector,” the report said.

ESMA also noted that financial markets have begun exploring the implications of generative artificial intelligence tools. “Their effect could be transformational, and authorities are working out the benefits and risks to consumers and financial stability,” the report said.

Staff

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