The RSM Brexit Stress Index reached its highest level since the U.K.’s June 2016 referendum to leave the European Union, closing at 1.93, up 8 points on Tuesday from 1.85 a week earlier, amid instability in the U.K. government.
Earlier in the day, Conservative Party Prime Minister Boris Johnson, who favors a stark separation from the EU by the deadline of Oct. 31, lost his government’s ruling majority after a member of his party joined the rival Liberal Democrats. Johnson, who has only been in the P.M. role for six weeks, could potentially be stripped of his power. The markets reflected uncertainty.
The composite index, which measures economic stress surrounding Britain’s impending departure from the EU trading bloc, has been escalating 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.
The financial markets are stuck somewhere between the risk associated with a Johnson-led government and a clumsy exit from the EU common market, and the risk of a government led by opposition Labour Leader Jeremy Corbyn, which market participants worry could threaten the capitalist status quo.
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 U.K. company profits are represented in U.S. dollar terms, according to an analysis by Shroders. This appears to account for the mean-reversion behavior of the U.K. 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.
Looking forward, the EU appears to have confirmed its commitment to an orderly withdrawal agreement from Britain before the Oct. 31 deadline, while the U.K. government seems set on the opposite.
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% of its value versus the euro, the first loss after three weeks of the euro being pummeled by the market’s focus on Germany’s manufacturing recession. The pound also lost -0.7% 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% 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% 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.