Stress in the financial markets nudged up during a tumultuous week that saw the EU grant an extension of the Brexit deadline to 31 January 2020, and Parliament grant Boris Johnson’s wish for a December 12 General Election.
The RSM Brexit Stress Index, which measures stress surrounding Britain’s impending departure from the European Union, rose slightly as the financial markets priced in a bit more volatility, uncertainty and risk to a Brexit saga that will now extend to nearly a year beyond its original exit date. The index closed at 0.83 standard deviations above normal levels, up from last week’s reading at 0.71.
Simon Hart, lead Brexit partner at RSM comments: ‘The markets seemed to have assigned a certain level of increased stress to these two recent developments. While the EU’s extension offered some relief and allows more time to resolve outstanding issues concerning the future relationship between the UK and EU, the election brings a host of other potential developments to the fore. Businesses seeking certainty will have to wait a while longer yet.’
In response, the currency markets were a bit bullish on the pound, while the equity market drifted lower and the bond market maintained its anticipation of slower growth.
The election and the medium-term prospect of progressing future trade agreements, not just with the EU but with wider markets leave an indeterminate amount of time for some degree of financial and economic uncertainty to continue.
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 British corporate bond spread.
The pound ended another up-and-down week and regained only 0.1 per cent of its value versus the euro on higher volatility, while gaining 0.4 per cent against a basket of its trading partners. The pound’s double-digit loss in value since the April 2015 onset of Brexit fever is likely to contribute to the strain on household balance sheets, which could be a factor in the public’s spending and political decisions.
The FTSE 100 moved lower over the course of the week, finishing 0.3 per cent lower than last week’s close. We would expect volatility to remain higher than normal until the Brexit details are reasonably sorted out.
The bond market remains wary of the potential for economic growth in Britain. The yield on 10-year gilts moved as low as 0.61 per cent before closing the week at 0.67 per cent, while the yield curve remained inverted. The corporate bond market maintained its spread over gilts.
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.