Euro area equity markets continue to recover from the severe decline experienced during the financial crisis, supported by market optimism about the economic recovery and diminishing risk aversion. Valuation measures based on price/earnings ratios using long-term trailing earnings figures suggest that the markets are not particularly overvalued (see Chart 9). Alternative valuation measures, based on expectations of future earnings, provide different signals. Moreover, risks for stock market prices remain, in particular those associated with an economic recovery that could turn out to be weaker than expected by markets. The euro area banking sector Let me now turn to euro area financial institutions, starting with the large and complex banking groups. Conditions in the euro area banking sector have improved markedly in the first three quarters of 2009, on account of better-than-expected macroeconomic news and the concomitant rebound in the financial markets. The euro area banking sector has also benefited from the various financial system support measures and the macroeconomic policy stimulus. The earnings and profitability of euro area major banks have recovered significantly, and across the board, in the first three quarters of 2009, after a dismal performance in the second half of 2008. Nevertheless, the dispersion of profitability across LCBGs continues to be wide (see the left side of Chart 10). The examination of individual revenue categories sheds more light on the factors explaining euro area LCBGs’ recent favourable performance (see the right side of Chart 10).

Nevertheless, the risk of a renewed deterioration in the US housing market and, therefore, possible further losses for households’ net worth in the US and the financial sector has not disappeared. While the pace of increase in delinquencies on mortgages and in foreclosures has been slowing down, the excess stock of vacant homes remains considerable and might continue to exert downward pressure on house prices. In addition, the demand for housing has been spurred by tax credits for first-time home buyers, but this incentive has a limited time horizon. In the US commercial property sector, developments have lagged those in the residential property market, both with regard to prices and activity. The recent steep fall in prices raises risks both for banks and other financial institutions that are directly exposed to the commercial property market and for investors in US commercial mortgage-backed securities. The outlook for US corporate sector has stabilised since May 2009, as quarter-on-quarter profit growth has turned positive in the first half of 2009. This has mainly been due to a turnaround in the profitability of domestic financial industries (See Chart 2). As a consequence, corporate sector default rates are expected to peak. Notwithstanding the improvement in total corporate profitability, there are risks: the increase in non-financial corporate profitability has been largely due to cost-cutting measures, which could not continue indefinitely, while weak demand prospects are expected to constrain revenue growth. The macroeconomic outlook in the non-euro area EU countries has improved, although there is still an unusually high degree of uncertainty.