RSM Brexit Stress Index reaches levels not seen since 2016 referendum

The RSM Brexit Stress Index reached its highest level since the June 2016 referendum to leave the EU, closing at 1.93, up from 1.85 the previous week, amid an increasingly volatile situation at Westminster.

Yesterday the Conservative Party lost its ruling majority in the House of Commons after one of its own members Phillip Lee MP defected to the Liberal Democrats. Johnson, who has only been in the PM role for six weeks, may be forced to try and call a general election, the implications of which are complex and numerous. The markets and this stress index reflect the enhanced uncertainty.

Brexit stress index

The Index, which measures economic stress surrounding Britain’s impending departure from the EU, has been increasing since the resignation of former Prime Minister Theresa May in June. High levels of financial market stress are associated with pullbacks in lending and borrowing practices, and slower economic growth in coming quarters.

Simon Hart, lead Brexit partner at RSM comments: ‘The financial markets are stuck somewhere between the risk associated with the higher stakes brinkmanship tactics of the Johnson-led government, and the different areas of uncertainty associated with a government led by Jeremy Corbyn, which market operators worry could threaten the capitalist status quo. The implications are numerous. Middle Market business leaders still have six weeks to prepare for Brexit, in order to be in the strongest possible position to offset the impending challenges. If a business prepares for a worst case or no-deal, in theory, anything else is a bonus.’

Two factors are holding the composite index from climbing higher than two standard deviations above normal levels of financial market stress. First is the direct impact of the German economic slowdown on the euro, which has been indirectly keeping the British pound afloat. Second is the equity market’s response to pound weakness, the logic being that a large portion of UK company profits are represented in US dollar terms, according to an analysis by Shroders. This appears to account for the mean-reversion behaviour of the UK equity market since the Brexit referendum, with stocks’ response to the ebb and flow of Brexit events often buffered by trends in the foreign exchange markets.

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 lost -0.4 per cent of its value versus the euro, the first loss after three weeks of the euro being negatively affected by the market’s focus on Germany’s manufacturing recession. The pound also lost -0.7 per cent against a basket of its trading partners’ currencies, all on higher volatility.

The FTSE 100 continued to benefit from the weakness of the pound, rising 0.8 per cent since last Friday on higher volatility. There were, nonetheless, nascent signs of the equity market pricing in uncertainty over U.K. politics and negotiations with the EU.

The yield on 10-year gilts lost another -7 basis points, closing below 0.41 per cent on Tuesday. The 10-year/three-month yield curve remains inverted by 36 basis points as investors factor in the prospect of slower growth and look for safe-haven returns.

Corporate spreads widened by another 2 basis points, as the bond market maintained its assessment of risk. 

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.