The RSM Brexit Stress Index moved higher again this week, as the market processed conflicting central banking trends: global equities pushed higher on an expected U.S. rate cut by the Federal Reserve and a quick turnaround in the U.K. bond market as the slim probability of a base rate cut by the Bank of England grew even smaller.
The composite index, which measures economic stress surrounding Britain’s impending departure from the European Union, closed at 0.26 on Friday from 0.16 a week earlier (see Figure 1). The index remains at 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.
Currencies have perhaps become the most pragmatic among the markets, losing ground for the tenth week in a row. In all, the pound has lost 16% of its value since 2015 when the Tories took power on the promise of Brexit (see Figure 2). As would be expected, retail prices moved higher from 2015 to 2017 in response to the weakening currency, which continued until the exchange rate plateaued and a drop in petroleum prices in late 2018 pushed the inflation rate lower.
Nevertheless, the relationship between a weakening pound and higher retail prices appears to have been reestablished of late, albeit from a lower level. The pound could weaken further if economic growth suffers during the transition away from Europe’s Common Market; consumers could expect higher retail prices, particularly if shortages were to occur if Britain’s departure from the EU disrupts the free flow of trade.
Looking forward, the European Union has extended Britain’s deadline to depart from the bloc to Oct. 31, which leaves months of uncertainty as leadership of the House of Commons takes shape and as the EU’s response to future government proposals become clearer.
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 was only slightly lower this week against the euro—which was hit by concerns over a manufacturing slowdown—and against an index of its major trading partners. The pound remains 5% lower in value since the elections in early May. Volatility increased during the week.
The FTSE lost 0.7% during the week, after five weeks of gains. Equity market participants are balancing the impact of a global slowdown and the reaction by the monetary authorities.
The yield on 10-year gilts increased 9 basis points, nearly recouping last week’s losses and mimicking yield increases in the U.S. and Germany. The UK yield curve remains inverted, but only out to five-year maturities as three-month yields moved 8 basis points higher on diminished expectations of a Base Rate cut.
Corporate spreads narrowed for the sixth week in a row.