Markets show signs of settling as delayed exit increases short term certainty

Stress in the UK financial markets diminished further at close of markets prior to the weekend, reflecting the likelihood that the EU would agree to delay Brexit. Indeed, yesterday the EU rubber-stamped a 31 January 2020 deadline thereby making the October 31 do-or-die date null and void. 

By Friday’s close, the RSM Brexit Stress Index, which measures financial-market stress surrounding Britain’s impending departure from the EU, had dropped to 0.71 standard deviations above normal levels, down from last week’s close at 0.86 and down from the nearly 2.0 during August’s darkest days of a suspended Parliament. 

Brexit stress index

Simon Hart, lead Brexit partner at RSM, comments: ‘A week is a terribly long time in politics. We’ve seen and heard a lot from Westminster and Brussels in terms of possible outcomes. The markets indicated last week via further destressing that some short-term certainty via a delayed Brexit was to follow. Indeed, that was confirmed yesterday. Whilst this delay will frustrate, it will also present to middle market businesses an opportunity to make further preparations. Having said all of that, it’s important to note that whilst the Brexit stress index is lower, it is still elevated and therefore wary of future risk.’

Performance of index components through Thursday October 17

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 UK corporate bond spread.

The pound ended an up-and-down week on the downside after Boris Johnson declared his intentions for a December election. The pound lost -0.3% of its value versus the euro on lower volatility, while losing -0.3% 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 higher during the first three days of the week before tailing off a bit and finishing the week 2.4% higher 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 UK economic growth. The yield on 10-year gilts moved as low as 0.62% on Thursday before closing the week at 0.68% and the yield curve 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.