The eurozone’s pre-war market calm is beginning to crack, according to a European Stability Mechanism brief by economist Martin Iseringhausen, as rising financial stress linked to the war in the Middle East threatens to add downside risks to economic growth.
The brief stated that financial conditions before the war were favourable, with strong equity valuations and low volatility signalling contained near-term growth risks. However, Iseringhausen found that market stress has increased since the end of February 2026, while a longer or re-escalated conflict could damage global investor sentiment and worsen macro-financial conditions.
War shock
Iseringhausen stated that financial conditions and market sentiment contain important information about the economic outlook. The ESM’s Growth-at-Risk model translates changes in financial conditions into risks to expected GDP growth, with a focus on severe negative growth surprises.
Before the war in the Middle East, euro area indicators pointed to limited downside risk compared with past stress episodes. This reflected benign conditions across asset classes, even though geopolitical tensions and policy uncertainty were already elevated.
That picture has become more fragile. Iseringhausen noted that the war’s impact on euro area growth forecasts is already visible, although it does not yet amount to a low-probability extreme adverse event under the pre-war outlook. He warned that this assessment could change rapidly if the conflict lasts longer or escalates.
Market stress
The brief found that financial conditions had improved steadily since the end of 2022, helped by rising asset prices, real credit growth and subdued market stress. However, Iseringhausen warned that war-related turmoil may end that trend. Since the outbreak of the war at the end of February, stock markets have declined and become more volatile, bond yields have risen and broader market stress has increased.
For markets, the warning is clear. The calm that supported benign growth-risk signals before the war may no longer hold. A longer conflict could weaken investor sentiment, tighten financing conditions and make companies and households more cautious.
Country risks
Iseringhausen found that growth risks vary significantly across euro area member states, reflecting differences in bonds, stocks, real estate, credit growth and market stress. The ESM estimated the model using quarterly data for 11 countries: Germany, France, Italy, Spain, Austria, Belgium, Greece, Finland, Ireland, the Netherlands and Portugal. The estimated results are then used to compute risk quantiles for all 21-euro area countries.
Even before the war, growth forecasts and downside risks varied widely. Several larger euro area economies were expected to record only mild growth, while many smaller member states were projected to continue growing strongly. Iseringhausen stated that countries with similar baseline forecasts can still show sizeable differences in downside risk because of their specific financial conditions.
Negative-growth risks
The brief stated that, despite robust financial conditions before the war, relatively low baseline forecasts mean several countries still face a sizeable chance of economic contraction. France had the highest probability among the countries shown, followed by Slovakia, Italy, Luxembourg and Finland.
Iseringhausen cautioned that these model-based numbers do not represent a formal recession probability, which is usually defined as two consecutive quarters of negative growth. They also do not include the full impact of the war in the Middle East.
However, the economist concluded that probabilities of negative growth are likely to increase as market stress rose in the first quarter of 2026 and baseline growth forecasts weakened.
AI risk
Iseringhausen also warned that markets may be vulnerable to a “macro-financial disconnect”, where asset prices and market stress indicators do not fully reflect underlying risks.bnThe brief highlighted the recent rally in artificial intelligence-related stocks as one area to watch. It stated that rapid growth in asset valuations can become risky when it becomes detached from economic fundamentals and is driven mainly by investor expectations of future price increases.
The economist warned that doubts about the growth potential of AI could trigger a sharp correction in equity valuations. Such a correction could signal sizeable downside risk to economic growth and create liquidity risks in non-bank financial institutions.
Policymakers urged to stay vigilant
Iseringhausen concluded that the Growth-at-Risk framework, when combined with other tools and expert judgement, helps provide an early warning signal for policymakers when financial stress points to higher downside risks. He stated that policymakers should remain vigilant not only in countries with more pronounced near-term risks, but also in those with strong asset price and credit dynamics, where vulnerabilities may build over time.
In summary, Iseringhausen emphasised that the eurozone economy is not yet in the danger zone, but the market calm that protected the outlook is starting to crack.
