Brexit is the gift that keeps on giving. England and the European Union had agreed to an 11-month window ending Dec. 31 to produce what would normally take years of trade negotiations. If those talks were to fail in the remaining three months of the year, then the U.K. will face tariffs imposed by the E.U., its largest trading partner, once it is pushed out.
Given the recent economic dislocation, a rushed Brexit may not be the optimal policy path toward a recovery.
Given the economic dislocation wrought by an unforgiving pandemic, this may not be the optimal policy path toward a 2021 economic recovery. We would argue that this is not in the best interests of either party.
Moreover, British Prime Minister Boris Johnson’s late gambit to pull back on the Northern Ireland agreement carries with it the possibility of unwinding domestic and E.U. support for moving toward a mutually beneficial agreement.
After a summer lull, the financial markets seem to be paying more attention to those negotiations.
The plateauing of volatility in the currency market in recent weeks and a slight increase in equity-market volatility underscore the potential for the re-introduction of risk into the financial markets as the Dec. 31 deadline approaches. We show this in the first two figures below, where asset-price volatility has spiked with major events in the Brexit timeline. (Note that in financial market parlance, increased volatility corresponds to increased perceptions of risk priced into securities.)
We measure the overall level of U.K. financial market risk with the RSM Brexit Stress Index, which is an amalgam of the performance of the British equity, bond and currency markets.
Most recently, the index spiked during the equity market’s collapse during the coronavirus outbreak.
As the first figure below indicates, one or more of the financial markets priced in additional risk at the time of major Brexit events — the 2016 referendum, England’s formal request and the E.U.’s acceptance of that request to leave the common market. Most recently, the index spiked during the equity market’s collapse during the coronavirus outbreak.
The RSM Brexit Stress Index is 1.35 standard deviations above normal levels of risk. An index value above 1.96 standard deviations is considered to present conditions of abnormal risk. Excessive risk in the financial markets implies diminished willingness to borrow and to lend, with the lack of investment presenting a setback for an economy attempting to recover from the coronavirus pandemic.
The bond market was already pricing in the prospect of lower growth before the pandemic hit. Because of the economic shutdown, the appropriate response by the monetary authorities was to push interest rates to the zero bound to maintain liquidity for commercial borrowing. The Bank of England has also engaged in security purchases, adding £745 billion to its balance sheet, which maintains the demand for long-term securities while limiting their supply, and pressuring bond yields lower.
In the currency market, perceptions of the stability of the pound relative to the euro are in turn subject to the stability of the euro and the pound versus the dollar. This presents the daunting task of reconciling changes in the value of the pound (and the euro) with conflicting views on the demand for dollars, which now seem to be dependent on the development of a COVID-19 vaccine and the speed of a U.S. economic recovery from the pandemic — all relative to pandemic-linked developments in England and Germany.
In the equity market, the FTSE 100 has lost 20% of its value relative to last year, but even that is an improvement over the losses in March. The performance of the equity market is perhaps most valuable as an indicator of asset bubbles or investors’ loss of confidence, which as we’ve seen can have a disastrous impact on overall financial stability and the health of the economy.
As the last figure shows, England’s economy is shrinking at a rate of 21.7% relative to last year’s output. Manufacturing output, which has ripple effects throughout the economy, is shrinking by 14% (as of June, the latest month available), an improvement over the previous two months.
The last thing that England (or for that matter, the E.U.) economy needs is for the negotiating committees to become unreasonable. The pandemic has added a terrible wrinkle to the efforts to leave the common market.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.