Despite positive market sentiment, valuation and volatility risks have increased and “merit investor attention”, according to ESMA, the European Securities and Markets Authority.
Noting that “Prevailing optimistic market sentiment was at odds with sluggish underlying economic fundamentals, but in line with the ultra-low interest rate environment,” the regulator said risk appetite remained strong as yields continued to fall while high-yield bond issuance was “readily absorbed by markets”.
“Consequently, valuation concerns rose along with the risks of future volatility and its effects,” ESMA said.
The Report commented that the risk of “critical market corrections” rose further, adding that the systemic impact of any correction “could be exacerbated by liquidity bottlenecks, such as might arise from thin dealer markets or rising collateral requirements.” While ESMA said it was maintaining its overall systemic risk assessment for 2Q14, it expects “a further deterioration in market and liquidity risks in the third quarter, which may trigger revisions.”
The Dashboard said that “Intensified hunt-for-yield behaviour based on overly optimistic assumptions continues to be a concern and can lead to significant misallocation of capital.”
It expressed concern about credit risk, the only one of four risks it labelled ‘red/very high’. “Depending on the degree to which high valuations are credit-fuelled, a change in real debt burdens could have significant implications,” it said. “Where prices are fuelled by short-term and cheap credit rather than expectations about economic recovery, valuation risk would further rise.” Liquidity risk, market risk and contagion risk were all labelled ‘yellow/moderate’.
ESMA's press statement with links to the two reports can be accessed by clicking here.