It’s usually a Jeremy Grantham or John Hussman from whom one expects a gloom and doom report on the economy and investing, whereas a central bank like the Fed seeks to calm investors with soothing references to “financial market stability,” ascribing negative developments to “transitory factors.”
But the Fed’s transatlantic cousin, the European Central Bank, has just issued its biannual Financial Stability Review, and despite the soothing name, the report has plenty of fodder for the investment industry’s professional worrywarts.
Weighing in at 173 pages, the tome starts off promisingly enough with the placid assurance that Eurozone financial conditions have been calm over the past half year.
That may be the calm before the storm, however, as the document goes on to describe a series of systemwide vulnerabilities contained within — or perhaps triggered by — an essentially dichotomous risk environment, which the ECB puts thusly:
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“In sharp contrast to the rise in financial risk-taking, economic risk-taking in the euro area is clearly lagging. This is vividly illustrated by the contrast between appreciating financial asset prices and a low level of real investment, which still remains below that of 2008, after a much more marked fall than those seen after previous recessions.”
In other words, asset prices are rising sharply, even though the economic fundamentals lag, leading to a “medium-level systemic risk” that would ensue from an “abrupt reversal” in global asset prices.
The ECB sees two main potential triggers for the reversal, and interestingly a Greek debt default isn’t one of them. (Indeed, the impact of prolonged negotiations over Greece was largely contained, triggering “only minor volatility in sovereign yields.”)
Rather, European central bankers worry most of all about their American colleagues:
“In particular, a faster than expected withdrawal of U.S. monetary policy accommodation harbors some potential to translate into higher risk premia, even in the euro area,” says the report.
Trigger No. 2 relates to “geopolitical tensions and emerging market risks, notably related to the BRIC countries (Brazil, Russia, India and China) that had operated as a key driver of global economic growth in the last few years.”
To get a picture of what these risks look like, here’s the scenario the ECB has used in its stress-testing of European financial institutions:
“A negative confidence and stock price-driven shock emanating from the United States is assumed. Simultaneously, adverse effects are assumed to materialise in major emerging markets, namely a financial market shock accompanied by a slowdown of potential GDP growth. These shocks, in turn, would lead to a recession in the United States and a sharp slowdown in key emerging market economies, and would – via trade and confidence spillovers – have negative implications for the global economic outlook. This effect also includes the impact of derived increases in oil and other commodity prices. In addition, the reversal of the search for yield is assumed to lead to a marked worldwide increase in corporate bond spreads from their current low levels.” A second medium-level systemic risk the report addresses is “weak profitability prospects for banks and insurers in a low nominal growth environment, amid slow progress in resolving problem assets.”