The RSM Brexit Stress Index levelled out this week, maintaining high levels of stress as Germany’s manufacturing recession came front and centre for the foreign exchange market.
The Index, which measures economic stress surrounding Britain’s impending departure from the European Union, closed at 1.64 on Friday from 1.69 a week earlier, still significantly above normal levels.
Simon Hart, lead Brexit partner at RSM, comments: ‘Despite the pound gaining on the Euro last week, wider macro and micro economic factors mean that current stress levels will continue in the short to medium term. Britain’s equity market had lost nearly 3 per cent at one point during the week and the yield on 10-year gilts dropped by nearly 10 basis points - not-so-subtle signals of expectation surrounding the UK’s departure from the European Union and future asset-market returns. Middle market businesses in the UK need to ensure they’re prepared ahead of future shocks and continued economic volatility at best.’
Because an exchange rate is a two-sided asset, its value at any one time can be determined by perceptions of economic growth in either of two countries independently or relative to each other.
A week ago, all eyes were on the negative quarterly growth in the UK, and the pound suffered. And although UK and German manufacturing outputs are co-dependent and have been declining together throughout 2018-2019, this week’s market focus centred on German manufacturers’ reduced expectations, and subsequently, negative German real GDP growth in the second quarter—both working to pull the euro’s side of the coin down.
The current state of political discourse seems most likely to be pound-negative, particularly if the UK economy were to show signs of stumbling.
Performance of index components
The RSM Brexit Stress Index is made up of six components; they include the British pound-euro exchange rate and its volatility, the FTSE 100 and its volatility, the gilt yield spread and the U.K. corporate bond spread.
The pound recovered last week, regaining about 2 per cent of its value versus the euro and 0.9% against a basket of its trading partners, all on a slight reduction in volatility.
The FTSE 100 continued its losing streak, dropping by 1.9 per cent by the end of the week on higher volatility.
The yield on 10-year gilts reached as low as 0.40 per cent during the week, but ended at 0.47 per cent, only two basis points lower than last week’s close. The 10-year/three-month yield curve remains inverted by 30 basis points on concerns over the direction of U.K. and global growth.
Corporate spreads widened by six basis points on perceptions of an increased risk of business failures should Brexit or US trade policies threaten global trade and growth.
The RSM Stress Index tracks six variables:
1. British pound/euro exchange rate
An exchange rate measures expectations of relative interest rates and the demand for one currency relative to another due to trade and current account flows.
2. Volatility of the British pound/euro exchange rate
Low volatility suggests a stable environment in which to make investment or trade decisions. A spike to high volatility indicates uncertainty in the market.
3. Equity market performance
In the absence of shocks, stock indices show a tendency to grow over the years. We look at the weekly level of the FTSE 100 Index relative to the same week of the previous year.
4. Equity market volatility
Spikes in the volatility of the FTSE 100 suggest the potential of a shock and an environment of uncertainty.
5. Yield curve spread
A steep yield curve indicates the market expects sustained, long-term growth. A flat yield curve indicates the market is expecting low levels of growth.
6. Corporate yield spread
The corporate yield spread measures the risk of holding a corporate security versus the safety of a risk-free government security. The higher the spread, the more the perceived risk of economic distress and the prospect of corporate defaults.