ECB warns of corporate weakness amid inflation and slower growth

Some companies in the euro zone risk being overwhelmed by the combination of rising commodity prices and slower economic growth due to Russia’s invasion of Ukraine, the European Central Bank has warned.

The region’s financial system must also brace for the possibility of a further correction in asset markets as the conflict lingers and monetary stimulus is withdrawn to combat record inflation, officials said in their semi-annual Financial Stability Review released on Wednesday.

“The terrible war in Ukraine has brought immense human suffering,” said ECB Vice-President Luis de Guindos in a statement. “It has also increased risks to financial stability through its impact on virtually every aspect of economic activity and financing conditions.”

Russia’s attack in late February sent commodity prices higher while hurting business and consumer confidence and dampening the recovery from pandemic restrictions.

ECB officials remain determined to start raising rates in July, with the debate shifting from the timing of the rate hike to the pace at which policy should change in the coming months.

Forecasts for economic growth this year have been revised downwards, while inflation in the 19-nation currency bloc will average over 6 percent, according to the European Commission.

This environment is particularly challenging for businesses – including air travel, accommodation, food and drink – which have never really recovered from Covid-19 restrictions, the ECB said.

“These vulnerabilities are compounded by the prospect of tighter financing conditions, which would affect the debt-servicing capacity of lower-rated companies in particular,” the report said.

The war in Ukraine and the prospect of tighter monetary policy have contributed to a sell-off in equity markets, with major indices in the region falling more than 10 percent year-to-date.

Further downside cannot be ruled out as the conflict drags on, the ECB said.

“Despite the recent corrections in asset prices, valuations remain stretched given the deterioration in macro fundamentals and further sharp corrections are a risk,” the report said.

“Such corrections could be triggered by a further escalation of the war, tensions in emerging markets, or persistent inflation than currently expected, which could result in faster normalization of monetary policy by major central banks.”

Officials also warned of vulnerabilities in the euro area’s housing sector, where prices rose at their fastest pace in 20 years in the last quarter of 2021 – helped by low interest rates, shifting preferences due to the pandemic and higher input costs.

“While short-term house price pressures will be supported by tight supply conditions and sustained demand as households and investors prefer residential real estate, signs of overvaluation leave some property markets vulnerable to price corrections,” it said.

While the ECB warned that banks could be indirectly affected by the war and its impact on supply chains and commodity prices, the analysis suggests that they are overall “resilient to the second-round effects” of the conflict.

In part of the report released earlier this week, officials also warned that the dramatic increase in the size and complexity of crypto markets means the sector is on track to become a risk in dire need of regulation.

While recent volatility has not proven contagious to the rest of the financial system, the threat is growing as institutional investors become more involved, they said.