The European Securities and Markets Authority warned of a 'prolonged period of risk' to both institutional and retail investors, including 'possibly significant' market corrections in the months to come
Europe’s main financial watchdog warned that strong gains posted by stock markets across the region could be unsustainable, with investors urged to brace themselves for further turmoil as a result of the Covid-19 pandemic.
In an unusual missive, the European Securities and Markets Authority in a 2 September report warned of a “prolonged period of risk” to both institutional and retail investors, including “possibly significant” market corrections in the months to come as the pandemic continues to wreak havoc on the global economy.
Esma cited a high risk of “decoupling of financial market performance and underlying economic activity” and that “the sustainability of the recent market rebound remains a concern”. Esma based its report on the first half of this year.
The warning seemed to “go beyond its remit,” said Colin Mclean, chief executive of SVM Asset Management.
“Undoubtedly there is a period of risk ahead, but it is far from clear that this is principally from a market correction,” he said. “The March low was driven by panic selling in the absence of much information and few investors participated. It does not seem a good starting point for any measurement.”
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According to the regulator, equity markets in Europe have surged by 40% since their lows in mid-March – the period during which global stock markets were rocked by a mass sell-off, prompted by the global spread of Covid-19.
Britain's FTSE 100 is up 19% from its low point in March, while Germany’s DAX has posted a more than 55% gain since the market rout.
Esma said the extent to which markets will suffer major corrections depends on the overall economic impact of the pandemic, as well as how other external events might hit “an already fragile global environment”.
A recent report by UBS analysts suggested the recent stock market rally had been driven by optimism surrounding a Covid-19 vaccine, claiming vaccine news accounted for around 6.5 percentage points of gains for the S&P 500 since May.
Russ Mould, investment director at AJ Bell, the investment platform, said it is “fairly unusual" for a regulator to make comments about potential market corrections.
“It is their job to try and maintain order in markets, so they may feel a word of caution is appropriate under certain circumstances,” said Mould.
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One factor that some have predicted could thwart a recovery is the emergence of new Covid-19 infections, which have been reported in some European countries.
However, Bank of America published a recent report suggesting this was unlikely to have an impact.
“There are reasons to think that the daily case count overstates the deterioration in the European virus situation and that the renewed rise in virus cases is unlikely to derail the European recovery,” Bank of America said in a research note on 28 August.
Among the reasons cited by the bank were that higher case numbers are partly a function of increased testing and that the virus is showing signs of becoming less deadly, therefore reducing the risk of harsh containment measures.
Bank of America also suggested that given the economic damage caused by the global lockdown at the height of the pandemic, governments are likely to respond to new cases with more localised measures.
However, Mould pointed to several factors which could influence how markets recover from the pandemic over the coming months.
“Huge amounts of fiscal and monetary support have been thrown at the global and European economies, interest rates are rock-bottom and not going up, and it seems clear that more stimulus will be offered in the event of a second wave,” he said.
“This combination could be persuading investors to flee cash, either in search of income or capital gains or to simply avoid holding what they may see as debauched currency as ever more of it is created, either through QE or experiments with universal basic income or plain old fiscal policy.”
Mould added that it could prove difficult for central banks and governments to “strike the right balance” between supporting the economy and keeping markets in check so they do not become overheated.
“There are some danger signs in the US and if there is a major second wave then some valuations could offer little downside protection,” he said.
“Equally, more QE, lower rates and higher fiscal deficits could persuade investors to stick with financial assets and eschew cash, so these are very interesting times.”
However, Vicky Pryce, a board member at the Centre for Economics and Business Research, said Esma was right to sound caution over the market rebound.
“After all, it wants an orderly market and no chaos if trends suddenly get reversed,” she said.
“We have seen huge differences in fortunes with technology and life science stocks doing well and most of the travel and hospitality industry in the doldrums. And it is fair to wonder whether the recent exuberance is sustainable in the face of high unemployment and prospects of deflation in the western world, but also in most emerging markets.”
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