The RSM Brexit Stress Index jumped in a week that included the European Union’s stark criticism of Prime Minister Boris Johnson’s withdrawal proposal and the equity markets’ recognition of the adverse effects of disruptions to trade.
The composite index, which measures financial-market stress surrounding Britain’s impending departure from the European Union, closed the week at 1.40 standard deviations above normal levels of stress, up from last week’s close at 1.21.
The most striking political event was the European Parliament’s response to Johnson’s latest withdrawal proposals, which were characterized as unclear. The European Parliament stressed that it remained willing to move toward a workable solution and that it “continues to support an ‘orderly Brexit,’ based on the already negotiated withdrawal agreement”.
As significant as this was, the financial markets had arguably priced in the EU’s response. Equity investors were not, however, prepared for the World Trade Organization’s forecast of a sharp drop in global trade and its damage to the world economy.
“The darkening outlook for trade is discouraging but not unexpected. Beyond their direct effects, trade conflicts heighten uncertainty, which is leading some businesses to delay the productivity-enhancing investments that are essential to raising living standards,” the WTO said. It added: “Job creation may also be hampered as firms employ fewer workers to produce goods and services for export.”
The release of the WTO report was the catalyst for a global equity-market meltdown, with British stocks bearing the brunt in one of the biggest losses since the Brexit referendum. While the FTSE 100 has seldom reacted to Brexit events in a logical way, it seems easy to draw a straight line from the WTO’s outlook for global trade to the reaction of the FTSE 100, with the combination of Brexit and British politics the poster child for economic uncertainty.
The Benn Act requires Johnson to request an extension to the withdrawal period no later than Oct. 19, if there is not an agreement before then. Such an extension would most likely be calming for the markets. But there are loopholes and political permutations still to be worked out, leaving an indeterminate amount of time for financial and economic uncertainty to continue. This would argue for higher volatility and risk being priced into financial assets, and the prospect of further loss of potential economic output.
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 0.2% of its value versus the euro on slightly lower volatility, but gained 0.6% against a basket of its trading partners. The pound’s 15% loss in value since the Conservatives formed the government is likely to have a negative impact on household consumption and overall economic growth.
The FTSE 100 closed the week 3.6% lower on higher volatility, with U.K. equities caught up with global concerns for trade and growth.
The bond market maintained its assessment of the threats to economic stability and growth, with the yield on 10-year gilts dropping six basis points to end the week at 0.44%. The 10-year/three-month yield curve is now inverted by 32 basis points, signaling the potential slowdown in growth in the months ahead.
The corporate market confirmed the risk of further disruptions to growth, pricing an additional eight basis points to the spread over gilts.
