ECB's de Guindos warns financial markets are vulnerable to a sharp sell-off

Financial markets could face a sharp downturn in the event of any further shocks to the global economy, European Central Bank Vice-President Luis de Guindos told CNBC on Wednesday.

Earlier on Wednesday, the ECB published its May Financial Stability Review, saying that the euro area's stability outlook remained fragile in the aftermath of recent turmoil in the banking sector, which saw the failure of several U.S. regional banks and the emergency takeover of Credit Suisse by UBS.

Although it determined that bank resilience in a higher interest rate environment was not a concern in the euro area, with fundamentals remaining solid and regulatory intervention proving effective, the ECB said it is "possible that these events could lead to a reassessment of the profitability and liquidity outlooks for euro area banks."

Global stock markets made a robust start to 2023, given falling energy prices, China's reopening and the surprising resilience of the euro zone economy — driving equity valuations back above historical averages, the ECB highlighted.

This reversed abruptly in late February and March as a hawkish tone from central banks and unexpected stress in the banking sector roiled investors around the world. De Guindos said current market positioning rendered stocks vulnerable to any further macro surprises.

"There is the possibility of a correction in markets, and the reason is that valuations are high, are elevated, and if you look at, for instance, risk premia, they are quite compressed, so just in case that we have bad news with respect to the macroeconomic outlook, that could give rise to a correction of markets," de Guindos said.

The ECB report noted that the potential for "disorderly adjustments" in financial markets had spiked against a backdrop of tighter financial conditions and lower market liquidity. The banking sector turmoil of March led to a widening of credit risk premia in the euro area, the central bank said.

"By contrast, the fact that equity risk premia remain compressed in absolute and relative terms, especially in the United States, raises concerns over potential overvaluation. Equities may thus be more vulnerable to a disorderly price correction in the event of a further deterioration in the economic outlook," the report said.

"As such, risk sentiment remains fragile and is highly sensitive to surprises as regards the outlook for inflation, growth and monetary policy in mature economies."

This could take the form of more persistent inflationary pressures, forcing central banks into "more significant" policy tightening than the markets have currently priced in.

There are also risks to the banking system from any fragility in non-bank financial institutions, de Guindos highlighted.

"We indicate that interlinkages are relevant and are important, so that you cannot immunize what happens in the banking industry from the non-banking industry."

The ECB report said that, although the non-bank financial sector remains resilient for now, exposures to credit risk remain high, opening it to "the risk of material losses should corporate sector fundamentals deteriorate substantially."

"In addition, non-banks' exposure to property markets has increased markedly in recent years, rendering institutions vulnerable to ongoing property price corrections," it said.

"Strong links with banks, as an important source of funding for instance, could also give rise to additional vulnerabilities in the banking sector via liquidity and credit risk spillovers."