Stress testing Brexit: Deal or no deal?
Blog post
October 9, 2019
- As the Oct. 31 deadline for Brexit nears, we look at the potential market impact of two possible scenarios: deal or no deal.
- In our stress-test scenarios, a disruptive no-deal scenario could weaken the U.K. equity market by 15% and the GBP by 10% relative to the USD, as well as hurt corporate-bond markets.
- If the U.K. and EU reach a last-minute deal, however, the U.K. equity market could gain by 10% and the GBP could rise by 8% relative to the USD.
Milestone events and their effect on forex and equity markets
Source: MSCI. Key events in the Brexit story: 1) Referendum takes place, 2) EU agrees on Brexit deal, 3) Brexit vote fails in the U.K., 4) Theresa May steps down, 5) Boris Johnson takes office, 6) Parliament is suspended, 7) Parliament returns after U.K.'s Supreme Court rules the suspension unlawful and 8) Downing Street claims a deal is unlikely.
How disruptive could a no-deal Brexit be?
For the first scenario, we base the narrative on the analysis outlined in the International Monetary Fund's World Economic Outlook.3 The study acknowledges that the Brexit impact is already partially priced in, but that things could turn worse in the event of a no-deal Brexit. In the IMF's most severe scenario, the economy is disrupted by increasing tariff and nontariff trade barriers, border disruption and stricter immigration policies, with an adverse impact on economic growth.
Financial conditions in the U.K. and Europe would also tighten under this scenario, with both sovereign- and corporate-bond spreads rising as confidence drops, although the effect on sovereigns would be partially offset by monetary easing.4 The proposed market impacts for this scenario are shown in the exhibit below.5 In short, equity markets would drop, with the U.K. bearing the largest impact.6 Sovereign yields would decrease in the U.K. and Europe, while corporate spreads would widen. Both the pound and euro would lose value relative to the dollar.7
The stress-test scenarios and their assumed market impact8
Applied shocks | No-deal Brexit | UK leaves EU with a deal |
|---|---|---|
Applied shocks Equity predictive stress test Relative shocks | No-deal Brexit Equity predictive stress test Relative shocks | UK leaves EU with a deal Equity predictive stress test Relative shocks |
Applied shocks U.K. equity | No-deal Brexit -15% | UK leaves EU with a deal +10% |
Applied shocks German equity | No-deal Brexit -5% | UK leaves EU with a deal +6% |
Applied shocks U.S. equity | No-deal Brexit -3% | UK leaves EU with a deal +2% |
Applied shocks Interest-rate predictive stress test Absolute shocks in basis points | No-deal Brexit Interest-rate predictive stress test Absolute shocks in basis points | UK leaves EU with a deal Interest-rate predictive stress test Absolute shocks in basis points |
Applied shocks GBP 10-year govt. | No-deal Brexit -30 bps | UK leaves EU with a deal +15 bps |
Applied shocks EUR 10-year govt. | No-deal Brexit -10 bps | UK leaves EU with a deal +10 bps |
Applied shocks USD 10-year govt. | No-deal Brexit 0 bps | UK leaves EU with a deal 0 bps |
Applied shocks Credit stress test Relative shocks | No-deal Brexit Credit stress test Relative shocks | UK leaves EU with a deal Credit stress test Relative shocks |
Applied shocks U.K. credit spreads | No-deal Brexit +40% | UK leaves EU with a deal -15% |
Applied shocks EU credit spreads | No-deal Brexit +16% | UK leaves EU with a deal -10% |
Applied shocks Other credit spreads | No-deal Brexit +8% | UK leaves EU with a deal -5% |
Applied shocks Currency predictive stress test Relative shocks | No-deal Brexit Currency predictive stress test Relative shocks | UK leaves EU with a deal Currency predictive stress test Relative shocks |
Applied shocks GBP/USD | No-deal Brexit -10% | UK leaves EU with a deal +8% |
Applied shocks EUR/USD | No-deal Brexit -5% | UK leaves EU with a deal +3% |
What happens if a deal is struck?
Without commenting on the likelihood of a deal, it remains possible the U.K. will strike a deal with the EU. In such a case, our scenario envisions a (partial) reversal of what has been priced in over the past two years: Equity markets could rebound, with the U.K. outperforming European and U.S. equity markets; the pound and euro could strengthen against the dollar; and corporate spreads could tighten. We further assume that — along with the positive surprise to future expected growth — sovereign bonds may lose, as rates go slightly up (see above exhibit).
How are equity and bond markets impacted?
The exhibit below shows the impact on our hypothetical portfolios in local-currency and USD terms. Equity and corporate-bond markets would lose under the no-deal scenario and gain under the deal scenario, with the USD returns amplified in either direction due to the pound-dollar exchange-rate change. U.K. and European sovereign bonds would rally or lose value under the no-deal and deal scenarios, respectively, while U.S. sovereign debt is unaffected under both scenarios.
Returns of selected asset classes under the two Brexit scenarios
We approximate the hypothetical equity portfolio with the MSCI ACWI Index (and look at a country breakdown). The hypothetical U.K., euro and U.S. sovereign-bond portfolios are proxied by the Markit iBoxx GBP Gilts Index, the Markit iBoxx EUR Eurozone Index and the Markit iBoxx USD Treasuries Index, respectively. The U.K., euro and U.S. corporate-bond portfolios were constructed by the authors, using globally accepted selection criteria.
As the Brexit deadline approaches, investors can prepare for the possible outcomes. Markets have already partially priced in Brexit, but they could move in either direction — all depending on the nature of the exit.
Further Reading
1See, for example: Parker, G., Fleming, S., and Beesley, A. “Boris Johnson urges Varadkar to keep Brexit talks alive.” Financial Times, Oct. 8, 2019.2Note that there is also the possibility that the decision will be delayed, if the EU allows a further extension. In that case, the discussed market impacts could materialize later than the Oct. 31 deadline.3“World Economic Outlook: Growth Slowdown, Precarious Recovery.” International Monetary Fund, April 2019.4The tightening financial conditions and monetary easing offset each other. Based on market observations at the time of the referendum, we assume a rally in U.K. gilts.5Our stress test starts with making assumptions about broad market aggregates, as shown in the second exhibit. We then apply MSCI’s predictive stress-testing framework to propagate the main assumptions to all other risk factors impacting returns. The results shown in the third exhibit are generated based on this methodology, using MSCI's RiskMetrics® RiskManager®. Our assumptions of broad market aggregates are based on the narrative in the IMF working paper and have been informed by our analysis of historical data, but there is no historical period that exactly corresponds to our assumptions.6Note that, while the growth shock to the U.K. is relatively large, many companies in the MSCI UK Index have significant revenue exposure to foreign countries. Whereas these revenue streams may be negatively impacted by a no-deal Brexit in the long run, as barriers to trade become larger, in the short run a depreciation of the pound dampens this negative impact.7See, for example: Martin, K. “Why a hard Brexit is a threat to the euro as well as sterling.” Financial Times, Oct. 4, 2019.8MSCI clients can access these scenarios on MSCI's client-support site. These scenarios can then be used in MSCI's BarraOne® and RiskMetrics® RiskManager®.
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