The risk of a sudden stock market correction is rising amid a growing disconnect between strong market valuations and deteriorating economic and financial fundamentals, the European Securities and Markets Authority (ESMA) is warning.
In its latest risk monitoring report, the European regulators cautioned that while markets have proven resilient, this condition shouldn’t be confused with a lack of vulnerabilities.
Indeed, the growing gap between the equity markets and the underlying fundamentals raises the risk of sudden market reversal, if investor sentiment shifts abruptly or economic risks — such as higher inflation and weaker growth — materialize, it said.
“Investor optimism continues to support elevated valuations despite rising geopolitical tensions and a weakening economic outlook,” said Verena Ross, ESMA’s chair, in a release accompanying the report. “The wider this gap becomes, the greater the risk of an abrupt market correction. Retail and institutional investors should remain vigilant and retain resilience, preparing to be able to withstand sharp market corrections.”
Additionally, the regulators reiterated their concerns about “rapidly emerging threats to market infrastructures and key market players” from advances in cutting-edge AI models and the related cybersecurity risks. They also called for vigilance for signs of turmoil in private markets, including stress in the U.S. private credit markets and the “increasingly vulnerable” crypto sector.
In the asset management sector, interest rate and credit risks have been stable, ESMA said, but valuation risks remain an issue across most fund categories.