ESM sees euro zone recession if US sell-off, new Middle East war hit at once

By Julia Payne and Yoruk Bahceli

BRUSSELS/LONDON, July 6 (Reuters) - A renewed Middle East conflict and a U.S. asset sell-off are the two biggest risks to the euro zone, which, if twinned, could tip the euro area into a recession and send inflation near 5%, the European Stability Mechanism said in a report on Monday.

Europe is now far more exposed to U.S. financial markets than a decade ago. The euro zone's GDP exposure to the United States stood at 47% last year, compared with 18% in 2013, the ESM said in its first annual report.

"Rising political uncertainty, longer-run fiscal sustainability concerns, and stretched equity valuations built on artificial intelligence-related earnings expectations create the potential for a sudden asset price correction emanating from the U.S.," the report said. 

The ESM, a European crisis fund worth over €430 billion ($491 billion), outlined this vulnerability alongside the possibility of a new Middle East energy shock. 

The Iran war and the energy crisis stoked by closure of the Strait of Hormuz, a vital shipping lane, have had a major impact on the global economy and rattled financial markets. 

U.S. and Iranian negotiators have yet to agree a lasting peace since their interim deal last month. 

If conflict resurfaces and U.S. policy uncertainty similar to last year's tariff shock hits financial markets, the euro area's GDP may only rise 0.6% in 2026 and contract by 0.4% in 2027, the ESM said. 

The main channels that could lead investors to lose confidence in U.S. assets are concerns resurfacing about U.S. fiscal dynamics and the Federal Reserve's independence, the ESM said.

U.S. equity valuations could also adjust abruptly if optimism around AI investments fades.

The interaction of renewed conflict and a U.S. asset sell-off could send U.S. stocks almost 20% and European shares nearly 30% lower over 18 months, while U.S. Treasury yields would rise more than 50 basis points, it said. The euro would rise around 2% against the dollar.

"The euro area has large and increasing holdings of U.S. portfolio investments. At end-2025, the U.S. accounted for nearly half of the euro area's total global portfolio holdings — 59% of equity positions and 36% of debt, compared with roughly one-third in 2013," the report said. 

"Therefore, a material repricing of U.S. assets would bring substantial direct losses for European investors."

The ESM also sees the rapid expansion of private credit markets among additional vulnerabilities.

($1 = 0.8758 euros)

(Reporting by Julia Payne and Yoruk Bahceli; Editing by Aidan Lewis, Andrei Khalip, Amanda Cooper)