Despite the immense social and economic disruption in the wake of the coronavirus (COVID-19) pandemic, the European Central Bank (ECB) reports that decisive policy responses have helped to prevent a seizing-up of the financial system. However, even as infection rates fall in many countries, the impact on the economy and markets has unearthed and increased existing vulnerabilities for euro area financial stability, according to the ECB's May 2020 Financial Stability Review (FSR). Financial stability risks could arise as these vulnerabilities, identified in earlier issues, interact with the pandemic. These include richly valued asset prices, fragile investment funds, the sustainability of sovereign and corporate debt, and weak bank profitability.

“The pandemic has caused one of the sharpest economic contractions in recent history, but wide-ranging policy measures have averted a financial meltdown,” said Luis de Guindos, ECB vice-president. “However, the repercussions of the pandemic on bank profitability prospects and medium-term public finances will need to be addressed so that our financial system can continue to support the economic recovery.” 

As the virus spread globally in late February, financial markets saw dramatic falls in asset prices, sharp increases in volatility, illiquidity in some core markets and a general tightening of financial conditions. Some market reactions were amplified by the need for investment funds to sell assets to meet large outflows. Action by central banks globally, notably the ECB’s announcements of large-scale asset purchases (under the public sector purchase programme and the pandemic emergency purchase programme), helped stabilise conditions in markets.

All euro area countries announced fiscal packages to cushion the economic ramifications of the crisis for households and companies. These fiscal measures should support the economic recovery. In particular, they could help the many corporates that are now facing cash flow strains. Some riskier firms, which had levered up in recent years, are likely to face additional challenges. Looking ahead, the associated increase in public debt levels could also trigger a reassessment of sovereign risk by market participants and reignite pressures on more vulnerable sovereigns.

Although supported by a significant increase in capital and liquidity since the global financial crisis, bank valuations fell to record lows and funding costs increased. This reflected both the deterioration in economic prospects and considerably higher uncertainty about the outlook for euro area banks’ profits and asset quality. Mirroring changes in corporate earnings expectations and weaker income generation on new business, the return on equity for euro area banks in 2020 is now expected to be significantly lower than it was before the pandemic.

Banks should benefit from the action of prudential authorities across the euro area to ease capital requirements and grant banks more operational flexibility to maintain the flow of credit to the economy. In addition, ECB Banking Supervision recommended that banks temporarily refrain from paying dividends or buying back shares, strengthening their capacity to absorb losses and avoid deleveraging. These capital measures are expected to remain in place until the economic recovery is well established.

Australian data reflects global business decline

Despite the actions that countries around the world have taken to prop up businesses, firms all over the world have suffered a deep dip in activity as a result of the fallout from the pandemic. This is encapsulated in recent data from Australia, which showed a further steep decline in business activity in May.

While the impact of COVID-19 on the Australian economy looks to remain severe, May is an expected low point, according to initial results of the latest CBA Purchasing Managers Index (PMI).

The index highlights that Australia’s services and manufacturing sectors have both experienced continued steep declines in business activity in May, with the downturn easing slightly for service providers and intensifying for manufacturers compared to last month.

It appears the easing of some coronavirus restrictions was insufficient to prevent a further sharp drop in demand across the services sector, while manufacturers have cited widespread supply chain delays and issues with imported goods.

The headline Commonwealth Bank Flash PMI Index in May was 26.4, slightly up from 21.7 in April, with the Flash Services Business Activity Index at 25.5, up from 19.5 in April, and Flash Manufacturing PMI at 42.8, down from 44.1 in April. It is important to note that any reading below 50 signals a deterioration in business activity on the previous month.

“Another incredibly weak result that indicates the contraction in business activity observed in April intensified over May," said Gareth Aird, head of Australian Economics at Commonwealth Bank. "Two consecutive reads in the twenties is simply astonishing as well as concerning. It is likely that only a manufactured slowdown due to imposed restrictions could produce such results.”

Encouragingly, companies are much more confident this month about the 12-month outlook than they were in April, with business confidence in May jumping sharply to the highest in eight months. Sentiment was up in both the manufacturing and services sectors, with anecdotal evidence suggesting that businesses expect output to rise over the coming year as restrictions are lifted and conditions gradually return to normal.

“May should mark the low point in the PMIs and we would expect activity to lift from here on a monthly basis,” Aird said. “Company views on the economic outlook have improved and the lift in confidence is welcome. That said, it will be a long time before activity returns to pre-COVID-19 levels. And deflationary pressures highlight the huge amount of slack we have now in the economy.