The RSM Brexit Stress Index surged sharply during the week amid attempts by Boris Johnson, the Conservative Party prime minister, to curtail objections to a no-deal Brexit but eased at week’s end as Parliament regained control of government.
The index rose as high as 1.97 standard deviations above normal at midweek, its highest level since the June 2016 referendum calling for Britain’s departure from the European Union. The composite index, which measures economic stress surrounding the U.K.’s impending withdrawal slated for Oct. 31, closed the week at 1.42 standard deviations above normal, showing that stress in the markets receded.
The high levels of financial market stress are associated with pullbacks in lending and borrowing practices and slower economic growth in coming quarters. U.K. industrial production had already begun decelerating at the end of 2017 as the mechanics of Brexit became apparent, and producers were forced to consider the higher costs associated with disruptions to their supply chains.
The decline in U.K. output came amid growing recognition that an era of global economic recovery and prosperity was at risk as the United States began its foray into trade wars with its allies and competitors alike. Germany’s deceleration in industrial production coincided with the implementation of U.S. tariffs on China in the spring of 2018. Germany’s industrial output has now reached a -4.5%-per-year rate of decline and forecasters are anticipating a -1.2% yearly rate of decline for U.K. industrial production in July.
Looking forward, Parliament appears to be working toward requiring Johnson to seek an extension for the Brexit deadline to the end of the year or beyond, leaving an indeterminate amount of time for the political and financial uncertainty to continue. This could portend higher volatility and risk being priced 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.
The pound regained 0.7% of its value versus the euro and volatility receded by the end of the week as the market’s focus turned once again to Germany’s manufacturing recession. The pound lost -0.1% against a basket of its trading partners’ currencies due to dollar strength and on-again hope for U.S.-China trade talks.
The FTSE 100 moved higher at the time of Wednesday’s Parliamentary moves, then retreated a bit, before ending the week with a 1% gain on slightly higher volatility.
There was a split decision in the bond market. Caution first pushed 10-year gilt yields as low as 0.35% on Tuesday before Parliament took action. Yields increased to 0.65% on Thursday and ended the week just above 0.5%. The corporate market was not convinced, however, pricing in an additional 5 basis points of risk.
The 10-year/three-month yield curve remains inverted by 26 basis points as investors factor in the prospect of slower global growth and an eventual response by the monetary authorities.
