“Prolonged Period of Risk to Institutional and Retail Investors of Further – Possibly Significant – Market Corrections”

European Market Regulator flags big issues, including the “decoupling of financial market performance and underlying economic activity.”

The European Securities and Markets Authority (ESMA) warned of a “prolonged period of risk to institutional and retail investors of further – possibly significant – market corrections and very high risks” across its jurisdiction.

“Of particular concern” is the sustainability of the recent market rebound and the potential impact of another broad market sell-off on EU corporates and their credit quality, as well as on credit institutions.

The “decoupling of financial market performance and underlying economic activity” — the worst economic crisis in a lifetime — is raising serious questions about “the sustainability of the market rebound,” ESMA says in its Trends, Risks and Vulnerabilities Report of 2020.

Beyond the immediate risks posed by a second wave of infections, other external events, such as Brexit or trade tensions between the US and China, could further destabilize fragile market conditions in the near term.

From a long-term perspective, the crisis is likely to affect economic activity permanently, “owing to lasting unemployment or structural changes, which might have an impact on future earnings.” The increase in private and public sector debt could also give rise to solvency and sustainability issues.

In corporate bond markets, spreads have narrowed but they remain well above pre-crisis levels, owing to heightened credit risk and underlying vulnerabilities related to high corporate leverage. There was also a wide divergence across sectors and asset classes in April and May. Across non-financials, the automotive sector suffered the largest decline, followed by the energy sector.

In one of the report’s rare positive notes, central counterparties (CCPs) proved resilient throughout the period, despite the surge in clearing activity coupled with the sharp rise in initial and variation margins. That said, there’s still a high risk of a further deterioration in credit quality, which is likely to spark a fresh round of credit downgrades.

The risks of “fallen angels” remain high, and securitized products (e.g. Collateralized Loan Obligations (CLOs)) could also be affected. “The COVID-19 crisis is disrupting markets in ways that were impossible to predict when CLO ratings were assigned before the epidemic”, ESMA notes.

This raises the likelihood of further credit downgrades as the crisis evolves. Recent developments in the leveraged loan market attest to (emphasis added) “a deterioration in loan documentation, a widespread decline of financial covenants and increased use of accounting techniques by borrowers to reduce their apparent financial leverage.” Taken together, these “magnify the risk” that when defaults occur, they are more likely to occur together – clustered across firms and sectors.

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