May 2021 FSR:
Cyclically adjusted price/earnings (P/E) ratios for the United States have reached historically high levels over the last year. In the past, periods of elevated valuations relative to earnings have tended to be followed by substantial market downturns.
In a scenario where investors reassess the likelihood and pace of monetary policy tightening, investor risk appetite is likely to decline, leading to a fall in equity prices. Such a scenario could arise, for example, in response to a series of upward surprises in inflation figures that leads investors to expect an earlier withdrawal of US monetary policy accommodation. The shift in yields could induce a risk asset correction, with potential spillover effects on markets outside the United States
Past empirical relationships imply that a 10% correction in US equity prices that is associated with a US monetary policy tightening shock might lead to a fall of around 9% in euro area equity prices
Past US equity market corrections have also been associated with increases in euro area corporate bond spreads for both investment-grade and non-investment-grade sectors. Overall, a 10% correction in US equity markets could therefore lead to a significant tightening of euro area financial conditions, similar to around a third of the tightening witnessed after the coronavirus shock in March 2020


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