RSM's Brexit Stress Index continues upward trajectory

The RSM Brexit Stress Index moved higher again this week amid continued market volatility on mainland Europe.

The composite index, which measures economic stress levels surrounding the UK’s impending departure from the European Union, edged upwards from 0.47 the previous week to 0.65 at the close of markets (see figure 1).

The increased volatility in the foreign exchange market occurred due to reduced expectations for Germany’s industrial sector that had already fallen below a negative three per cent yearly growth rate. Under the best of trading circumstances, that would be distressing for UK manufacturers.

Brexit stress index
Figure 1

While the index remains at above-average levels of stress, it is within a range of normality in terms of asset-price performance and volatility. Elevated levels of stress indicate a less-accommodative climate for investment and the potential for lower economic growth in the months ahead.

Simon Hart, lead Brexit partner at RSM, comments: ‘The gradual uptick in stress in our index mirrors that which we are seeing in the FX market with the deflation in Sterling seen this week and the sobering economic news from our trading partners on mainland Europe. It’s notable that this increased stress is influenced by economics rather than geo-political events such as the appointment of Mr Johnson as UK PM and his administration’s suspected policy implications. Given all that is going on outside of the UK, we would expect to see the index stress levels continue to move gradually upwards over the coming few weeks. As Sterling continues to fall against the Dollar and Euro, all eyes will be fixed on what many expect to be the roll out of an expansionary fiscal policy.’

Looking forward, the European Union has extended Britain’s deadline to depart from the bloc to Oct. 31, which leaves three months of uncertainty regarding the EU’s response to future UK government proposals for the terms of the exit.

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 ended the week only slightly down, but remains 5 per cent lower in value since the local elections in early May. Volatility moved higher over the week, as the foreign exchange market priced in its diminished outlook for German growth.

Equity markets among the UK’s trading partners staged a last-minute rally on news that US GDP growth stayed above two percent in the second quarter. The FTSE 1000 had traded higher earlier in the week during PM Johnson’s ascension, but ended only 0.5 percent higher by week’s end. 

The yield on 10-year gilts dropped just below 0.70 basis points and the yield curve inverted out to 10-years maturity on concerns over the direction of UK and global growth. The ten year/three month yield curve spread is now at negative nine basis points, its lowest level during the run-up to Brexit.

Corporate spreads narrowed for the seventh week in a row, perhaps having already priced in the increased risk presented by Brexit. 

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.