ECB warns of market correction risks on political instability

Bloomberg

The European Central Bank warned that the risk of an abrupt global market correction on the back of rising political uncertainty has intensified, posing a threat to banks, stability and economic growth.
“More volatility in the near future is likely and the potential for an abrupt reversal remains significant,” the central bank said in its twice-yearly Financial Stability Review published on Thursday. “Elevated geopolitical tensions and heightened political uncertainty amid busy electoral calendars in major advanced economies have the potential to reignite global risk aversion and to trigger a major confidence shock.”
The U.S. elections capped a period of unexpected political results that started with the U.K.’s vote to leave the European Union. Donald Trump’s victory increased volatility and heralds profound economic-policy changes whose implications for the euro area are still hard to gauge, the ECB said. While the currency bloc’s economy and financial system have remained resilient so far, more political instability in coming months may put pressure on weak banks and countries with high sovereign debt.
“We are in a new phase of weaker world trade” ECB Vice President Vitor Constancio said at a press conference in Frankfurt. “If, on top of that, there would be a wave of protectionist measures, world trade, and world growth would suffer.”
Constancio confirmed that the despite the risk build-up, the ECB still sees euro-area growth around 1.6 percent in 2017, with inflation rising to about 1.25 percent in the spring.
Even so, he stressed that some of the region’s lenders remain weak and need to continue addressing excessive costs and a high burden of non-performing costs.

Vulnerable Banks
“Vulnerabilities remain significant for euro-area banks,” the central bank said in its report. “Profitability prospects overall remain low across the euro area in a subdued economic growth environment.”
Even so, the U.S. election results spurred a pick-up in bank stocks as investors saw the risk of ever tighter regulation recede. If sustained, this would “provide some support for euro area banks’ profitability prospects,” according to the ECB.
The Frankfurt-based central bank also flagged the risk of a return of market pressure on the region’s highly-indebted countries as the spread of populism hinders reforms.
“Higher political uncertainty may lead to more domestically focused, growth-hindering policy agendas,” the report said. “This, in turn, could delay much needed fiscal and structural reforms and could in a worst-case scenario reignite pressures on more vulnerable sovereigns.”
That could put more pressure on central banks, whose aggressive monetary easing has already helped to reduce financial stress.
“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,” the report said. “Despite relatively volatile global financial markets, bank and sovereign systemic stress indicators for the euro area have remained fairly stable at low levels.”