The RSM Brexit Stress Index eased again this week, as Parliament took additional steps to prevent a reckless exit from the European Union. The index fell to 1.24 standard deviations above normal levels of stress at market close on Friday, down from 1.42 a week earlier. Though still high, this suggests an improvement from the dire conditions of just two weeks ago.
By the end of the week, Parliament had rejected a bid by Prime Minister Boris Johnson for a snap election; meanwhile, Scotland’s highest court found Johnson’s suspension of Parliament to be illegal.
Before Parliament took control of Britain’s impending departure from the European Union, the index—a composite measure of the financial market—was registering two standard deviations above normal. High levels of financial market stress are associated with pullbacks in lending and borrowing practices, and slower economic growth in coming quarters.
Recent economic releases show that U.K. growth is already trending downward into a climate that could easily stumble into recession. As we’ve reported before, growth in the U.K. manufacturing sector has been negative for four straight months, and rolling three-month growth of GDP was slightly negative in June and at zero in July.
Recent labor market data releases also indicate that U.K. employment growth continues to decelerate while wages increase, to be expected at the end of an economic expansion. Rising wages might work against calls within Parliament for a snap election or referendum, from the point of view of the Remainers.
The increase in wages could also be a factor in the Bank of England’s wait-and-see response to the global economic slowdown and the Brexit ordeal. The financial markets are giving only a very slight chance of the BoE cutting its base rate next Thursday, despite this week’s dramatic action by the European Central Bank and the certainty of a rate cut by the Federal Reserve next Wednesday.
The European Union had previously extended Britain’s deadline to depart from the bloc to Oct. 31, but Parliament appears to be working toward requiring Johnson to seek an extension to the end of the year or beyond. That would leave an indeterminate amount of time for the political and financial uncertainty to continue, resulting in higher volatility and risk pricing into financial assets, and the prospect of further loss of potential output and profit.
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.
After losing ground for 14 straight weeks beginning in May, the pound has appreciated for the past five weeks. The pound regained 1.0% of its value versus the euro during the week on reduced volatility. The pound gained only 0.2% against a basket of its trading partners, but remains 16% lower in value since the 2015 general election and the start of the Brexit process.
The FTSE 100 moved higher after Parliament rejected Johnson’s bid for a snap election, ending the week with a 1.2% gain on a substantial reduction in volatility.
In the bond market, the yield on 10-year gilts jumped 25 basis points, ending the week at 0.76%. The corporate market confirmed that optimism and priced in a slight reduction in risk.
The 10-year/three-month yield curve flattened, with the curve now inverted by only 2 basis points. The market can now anticipate the EU granting an extension or an orderly Brexit resolution, albeit within a climate of slower economic growth.