Concerns have now shifted to the implications of upside risks to inflation and downside risks to growth, the review said. Interest-rate hikes have led to rising funding costs for all sectors in the economy, and the ECB highlighted commercial real estate firms in particular. The outlook for CRE "has continued to deteriorate in a context of falling tenant demand and negative credit rating actions," the review said, adding that the stock prices of real estate firms have continued to underperform the overall market by a large margin.
The ECB review also warned of more stress to come.
"However, as duration lengthened in the financial system and the real economy during the low interest rate era, a major part of the impact of monetary tightening is yet to materialize, which will pose future challenges for financial and nonfinancial sectors alike. These concerns are amplified by the recent flareup in geopolitical tensions in the Middle East. They add to the uncertainty surrounding the macrofinancial outlook, not only because of possible adverse repercussions for energy commodities supply, should the conflict escalate further, but also given their potential to spark risk aversion in financial markets and undermine confidence in the real economy," the review said.
The eurozone also remains vulnerable to a recession. "While economic surprises have been to the upside in the United States in 2023, the news has been predominantly more negative than expected for the euro area and China," the review said.
Although forecasts indicate a soft landing for the eurozone, "a recession also remains a likely scenario."
The ECB cited the manufacturing Purchasing Managers' Index, which it said was historically a reliable predictor of GDP growth, position, which is "in clearly contractionary territory" — below 50 index points — as of the third quarter of this year. The one-year ahead GDP growth-at-risk estimate has a 5% probability that economic growth in the next 12 months will be lower than -1.6%, "which would mean a more severe contraction. This suggests that there are downward risks to overall economic activity in the euro area, albeit varying from country to country," the review said.
The ECB also warned of shocks such as credit events, adding that although market-based risk indicators suggest that investors expect a soft landing — with inflation declining toward central bank targets without triggering a recession — the historical evidence shows that "a benign scenario of this type is difficult (although not impossible) to achieve in practice, especially given the magnitude of rate increases in a short period of time."
The review added that in the eurozone and U.S., market volatility and risk premia have tended to increase after the conclusion of a hiking cycle, albeit with different time lags, and warned that "the potential underestimation of risk by market participants could therefore lead to a disorderly correction if there are any negative economic surprises or if market sentiment turns."