ECB Financial Stability Review: Soaring policy uncertainty leads to major shifts in market sentiment

Geopolitical and policy uncertainty have spiked from already high levels since the previous edition of the Financial Stability Review was published.

Just as uncertainties stemming from political risks within euro area countries were subsiding, external sources of uncertainty, notably those associated with the unpredictability of a broad range of US policies, have soared

A lack of clarity surrounds several important economic policy domains, including trade, regulatory and fiscal policies, as well as the level of commitment of the new US Administration to international cooperation

While it is hard to predict the medium to long-term implications of these individual layers of uncertainty, they entail a broad risk of geoeconomic fragmentation across the globe

Concerns remain that trade tensions could escalate into a trade war with the potential for significant adverse impacts on global growth, inflation and asset prices. 

As the euro area is a very open economy which is well integrated into global supply chains, vulnerabilities to these sources of risk are pronounced.

Intensifying trade tensions have triggered a spike in market volatility, fears of slowing economic growth and a sharp repricing in financial markets. 

Financial markets, particularly equity markets, remain vulnerable to sudden and sharp adjustments due to persistently high valuations and risk concentration. 

Real estate markets have shown signs of recovery but face headwinds from elevated uncertainty. 

The liquidity and leverage weaknesses of euro area non-banks could amplify market drawdowns. 

Euro area firms and households have seen balance sheet fundamentals improve in recent years, but trade tensions, high funding costs and a weaker growth outlook point towards future headwinds. 

Euro area banks’ asset quality remains robust, but non-performing loans and provisioning needs may rise in the wake of rising trade tensions.

The ability of banks to absorb further asset quality deterioration is supported by the strength of profitability and ample capital and liquidity buffers. 

Asset quality in non-bank portfolios may be impaired by deteriorating corporate fundamentals and property market conditions.

Planned increases in defence spending may unlock positive growth effects if focused on productive investment and sourced from within the EU. 

However, planned fiscal expansion could also challenge the balance sheets of euro area sovereigns.