RSM's Brexit Stress Index eases

The RSM Brexit Stress Index eased last week, as global equity markets pushed higher on news of a rapprochement among the parties in the US-China trade war and anticipation of an interest rate cut by the US Federal Reserve.

The composite index — which measures economic stress surrounding Britain’s impending departure from the European Union—fell to 0.16 from a subdued range  centred on 0.28 over the past month (see Figure 1). As equity markets recovered, the UK bond market absorbed the prospect of a manufacturing slowdown in Q2 after the pre-Brexit 29 March inventory build-up.

Figure 1
Brexit Stress Index

Events in the bond market could have the most consequential impact on the UK economy and the markets; the gilt yield curve finally inverted as yield on 10-year gilt yields moved below three-month money market rates (see Figure 2). 

Given the possibility that the next Prime Minister might opt for the no-deal Brexit option, in the short term at least, trading with the EU will be more difficult for the UK— its closest and largest trading partner (see Figure 3)— and the shape of the yield curve now reflects anticipation of slower growth in both the immediate future and the long run; the money market began pricing in the still small (but growing) possibility of a Bank of England rate cut later this year in response to slower growth.

The index reading is showing slightly above-average levels of stress, but 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.

Looking forward, the extension of the UK’s deadline to depart from the bloc to October 31,  leaves summer months of uncertainty as new leadership of the Government takes shape, the new EU Parliament and key officials in Brussels get into post and the EU’s response to any new UK proposals become clearer.

Figure 2
Brexit stress index

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 another 0.3 per cent of its value against the euro and 0.7 per cent against an index of its major trading partners. The pound remains more than 5 per cent lower in value since the local elections in early May. Volatility decreased slightly during the week.

The FTSE gained 2.2 per cent during the week, with volatility levelling off.

The yield on 10-year gilts dropped 15 basis points during the week, the largest drop since the E.U. granted Prime Minister Theresa May an extension on March 22. The yield curve inverted with the 10-year/three-month gilt spread now at negative 8 basis points, suggesting concern for future economic growth.

Corporate spreads narrowed by 3 basis points during the week, narrowing for the fifth week in a row.

Figure 3
Brexit stress index 

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.

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