The prospect of Britain’s departure from the European Union has created uncertainty in the economy and volatility in financial markets. Disruptions to the U.K. supply chain—a system built over decades within a European common market—will ultimately create losses for consumers through higher prices and diminished consumption choices.
RSM has developed the RSM Brexit Stress Index to measure Brexit’s impact on U.K. economy. The index is composed of six financial variables whose weekly performance indicates the market’s assessment of Brexit on trade, wealth, the business cycle and corporate profits. The RSM Brexit Stress Index tightened for the week ended March 8 to 0.7 standard deviations above neutral from 0.5 above neutral the week prior; however, it is important to note that the index has declined from over 2 standard deviations above neutral in December, mostly due to financial markets pricing in a reduced probability of a hard exit from the European Union. This implies that economic and financial risks around the policy choices to be made over the next few weeks have eased.
A brief history shows the index moved higher in the run-up to the 2016 Brexit referendum, moved lower in the long period of negotiations and preparations thereafter, and then spiked higher as consequences of an exit from the common market became real.
Index variables
The following variables make up the RSM Brexit Stress Index:
Expectations for foreign trade (via the currency market)
1. British pound/euro exchange rate
RSM uses the British pound/euro exchange rate relative to its pre-Brexit level to measure the degree of stress in the foreign exchange market. An exchange rate is a two-sided variable that measures expectations of relative interest rates (and the return on investment in one country relative to another) and the demand for one currency relative to another due to trade and current account flows.
Note that the pound appreciated against the euro in the run-up to the U.K.’s Conservative Party majority win in 2015, but then lost value once the prospect of a referendum became certain and as steps to leave the common market and disruptions of trade became reality.
In the current environment—rejection of Prime Minister Theresa May’s deals with the EU and talk of delay, or rethinking that another referendum might be the preferred option, the pound has been range-trading or perhaps leaning toward strengthening again.
2. Volatility of the British pound/euro exchange rate
Exchange rate volatility measures the standard deviation of exchange rate at any given time within the previous 90-day period. Low volatility suggests a stable environment in which to make investment or trade decisions. A spike to high volatility indicates uncertainty in the market.
In the case of the British pound/euro exchange rate, volatility spiked up both in the run-up to the Brexit vote and as Brexit negotiations became reality and political ramifications took hold. Recently the level of volatility has retreated but remains higher than normal.
Expectations of wealth
3. Equity market performance
Because stock indices have shown a tendency to grow over the years (in the absence of shocks), we look at the weekly level of the Financial Times Stock Exchange (FTSE) 100 Index relative to the same week of the previous year. The measure of performance of the FTSE 100 stock index is not only the factual return on an investment in the business sector, but also an indication of expectations for the direction of and acquisition of household wealth.
The diminished yearly rate of return of the FTSE 100 in the run-up to the election of the Conservative government in 2015 and the subsequent improvement in the run-up to the Brexit vote might be due to dissatisfaction with the labor government in the first instance, and expectations of Conservative activism in the second. The equity market losses after the Brexit vote could be construed as a reality check that there are indeed costs to Brexit.
In the latest period, the rate of return in the equity market is once more approaching positive levels, perhaps due to anticipation of a delay or reversal of Brexit.
4. Equity market volatility
As in the foreign exchange market, spikes in the volatility of the FTSE 100 suggest the potential of a shock and an environment of uncertainty. Volatility trended higher in the run-up to the Brexit referendum, and then retreated to normal levels in 2017 and 2018 before spiking upward as the Brexit negotiations came to the front. In recent weeks, volatility has retreated again, perhaps in response to the increasing prospect of delay and reversal took hold.
Expectations for the business cycle
5. Yield curve spread
The shape of the yield curve—as measured by the spread between the yield on 10-year gilts and three-month interest rates—is an indication of the market assessment of the direction of the business cycle. When long-term yields are substantially higher than short-term rates (referred to as a steep yield curve), the market is holding expectations of sustained, long-term growth. When long-term yields are somewhat equal to short-term rates (referred to as a flat yield curve), the market is expecting low levels of growth.
While the flattening of the yield curve in 2014 and 2015 was a reflection of expectations of low growth that probably helped the Conservatives win the majority in 2015, the continued flattening through the Brexit vote and stabilization thereafter most likely reflects the prospect of secular stagnation due to Brexit’s disruption of the supply chain.
Expectations of corporate profitability
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. Corporate bond yields include a premium to cover the risk of holding a security that has the potential of default. In the BSI, we utilize the JP Morgan Eurosterling Corporate seven to 10-year government bond spread. As the business cycle evolves and shifts, the spread between corporate bond yields and gilts indicates expectations of corporate profitability in coming years. The higher the spread is, the more the perceived risk of economic distress and the prospect of corporate defaults.
Brexit adds another dimension to the life span of a corporate entity. After decades of doing business within a common market and within an open labor market, there are likely to be corporate winners and losers. Interestingly, corporate spreads narrowed in the run-up to the Conservative’s election victory in 2015, and then spiked higher in early 2016 on Cameron’s seeking a “special status” for the U.K. within the common market.
Corporate spreads moved lower and stabilized after the referendum and then widened again as Brexit negotiations with the EU took shape. In recent weeks, the corporate spread has narrowed somewhat as Prime Minister May’s deal with the EU fell apart in Parliament and as talk began of a Brexit delay or reversal took center stage.
