European regulator warns of market correction risk as AI valuations stay elevated

The European Securities and Markets Authority (ESMA) has warned that stretched technology valuations and heightened geopolitical tensions are increasing vulnerabilities in EU financial markets, despite their continued resilience. The EU’s financial markets regulator and supervisor said persistent inflation, weaker economic growth and heightened volatility were testing markets, while strong performance in technology and artificial intelligence-related sectors had helped restore investor optimism and valuations. ESMA said this resilience should not be mistaken for an absence of vulnerabilities, warning that the growing gap between deteriorating macro-financial conditions and upbeat market valuations could increase the risk of sudden corrections if economic risks materialised or investor sentiment changed abruptly. The authority also highlighted rapidly emerging threats to market infrastructure and major market participants, including risks associated with frontier artificial intelligence. “Investor optimism continues to support elevated valuations despite rising geopolitical tensions and a weakening economic outlook. The wider this gap becomes, the greater the risk of an abrupt market correction,” ESMA chair Verena Ross said. “Retail and institutional investors should remain vigilant and retain resilience, preparing to be able to withstand sharp market corrections,” she added. ESMA’s second risk monitoring report of 2026 covers developments across key segments of EU financial markets during the first half of the year, while also examining UCITS market fragmentation, technology initial public offerings in the United States and prediction markets. Equity markets fell sharply following the outbreak of the Middle East conflict but subsequently recovered to, or above, their pre-conflict levels. ESMA nevertheless said elevated valuations alongside a weaker macro-financial and geopolitical outlook had increased the risk of abrupt corrections. In bond markets, concerns have emerged over funding conditions and the traditional safe-haven role of bonds, with sovereign yields rising and spreads widening. Market volatility has remained elevated despite broadly stable indicators for credit quality in the EU. The regulator also warned that less transparent and increasingly interconnected areas of finance require close monitoring, including private credit exposure to the US market and the growing links between increasingly vulnerable crypto-asset markets and the wider financial system. Key market infrastructures have continued to function during periods of market stress, with central counterparties handling volatile energy trading without disruption. Settlement systems did, however, experience a short-lived increase in failed transactions across asset classes in early April. ESMA said cyber risks were becoming increasingly important as developments in frontier AI continued to change the operational risk landscape. In asset management, fund flows and performance remained positive despite volatile market conditions, while interest rate and credit risks were emerging as growing concerns. Available risk indicators remained broadly stable, although valuation risk continued to affect most fund categories. The regulator also highlighted changes in retail investment behaviour as digital platforms have made it easier for individuals to access financial markets. While many investors continue to favour passive products for long-term investment, the same platforms can facilitate short-term and speculative trading. ESMA warned that exposure to social media content and gamification features could encourage uninformed or impulsive investment decisions. In market-based finance, IPO activity remained limited in the EU, while follow-on issuance stayed below historical averages. Corporate bond issuance remained strong, although the pace of short-term debt issuance moderated and refinancing risks increased. In sustainable finance, global tensions over climate policy and concerns about energy security continued to weigh on environmental, social and governance sentiment. ESG funds nevertheless recorded mixed developments, with renewable energy and transition-focused funds attracting inflows. The EU ESG bond market remained resilient, supported by growing use of proceeds linked to renewable energy projects. ESMA said equity tokenisation remained at an early stage, although adoption was gaining momentum. Recent exploits in decentralised finance had renewed concerns about interconnectedness and the possibility of financial spillovers. Investment in artificial intelligence continued to expand, reflected in the growing number of AI-focused funds, particularly those targeting AI infrastructure. Quantum computing has also attracted significant investor interest, with global and EU start-up funding reaching record levels in 2025. The ESMA warning comes as Cyprus faces some of the same external pressures highlighted in the report, particularly those arising from the conflict in the Middle East. The CBC said in its September forecasts that the conflict was expected to have a direct negative effect on the Cyprus economy through energy prices, tourism and non-residential private investment. The central bank’s baseline scenario assumes the conflict will continue until the final quarter of 2026, followed by a gradual de-escalation. Despite the disruption, the CBC said domestic demand, the labour market and large residential and non-residential investment projects were expected to support economic growth. Net exports are expected to make a negative contribution to Cyprus growth in 2026, mainly because of weaker exports following a decline in tourism revenue during the first half of the year. The CBC expects the contribution from net exports to turn positive in 2027 and 2028, largely because of a further recovery in tourism. The contrasting combination of economic uncertainty and continued investor optimism in European markets is central to ESMA’s warning, with the regulator stressing that strong asset prices do not necessarily mean underlying financial vulnerabilities have disappeared.