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Blog Posts — November 15, 2018

Preparing for a cliff-edge Brexit

by Christoph Schon, CFA, CIPM

When several key members of the UK government resigned the morning after the cabinet had decided to finally back Prime Minister Theresa May’s proposed withdrawal agreement, the probability of a so-called cliff-edge Brexit increased dramatically. News of Brexit Secretary Dominic Raab’s departure around 9am local time spurred a 1.5% drop in the pound against the US dollar, while the FTSE 100 lost 1.2% compared with a previous intraday high—or down 0.4% from the previous day’s close.

Even though the FTSE ended the day marginally in the black, we view this initial co-movement of exchange rates and share prices as very significant, as for most of the 29 months since the EU membership referendum, the interaction was reversed. While the pound shed 18% of its value against its American rival in the first 4 months after the vote, the UK stock market made more than 10% over the same period. We find it hard to imagine, though, that this pattern will continue.

In the aftermath of the June 23, 2016, referendum, the argument had been that a lower exchange rate for the pound versus the UK’s major trading partners would be good for the large, internationally operating companies that dominate the FTSE 100 blue-chip index. The effect was twofold, as foreign revenues would be converted at a more favourable rate, while British exports would become cheaper for foreign buyers. In addition, the lower value of the currency also made UK assets more attractive to overseas investors looking for a bargain. After all, the United Kingdom was still a member of the European Union at the time and would remain so for quite a while. And there was a good chance that a decent deal could be struck by the time the UK actually left the EU.

At last, markets seem to have realised that the hopes of an amicable withdrawal agreement are dwindling fast. The fact that the minister predominantly responsible for negotiating the terms of the contract is now distancing himself from the agreement is a bit hard to comprehend and, indeed, worrisome. The Prime Minister’s apparent inability to secure the full backing of even her own cabinet and the growing discontent from all directions of the political spectrum make it, in our view, very unlikely that the proposal will be approved by the House of Commons. The European Council so far appears to be sticking with the special summit scheduled for November 25, unless “something extraordinary happens.” We assume that a successful vote of no confidence against Theresa May—as already called for by arch-Brexiteer Jacob Rees Mogg—would qualify as such.

So, what can investors do to prepare for the hard Brexit that now seems more likely? We propose a stress test of a further significant depreciation of the pound’s value on a global multi-asset class portfolio. Many analysts seem to believe that the exchange rate against the US dollar could go as low as $1.10. This constitutes a drop of nearly 15% from current levels, which would be similar to the loss experienced after the Brexit vote. However, to estimate the movements of the pricing factors for all asset classes in the portfolio, we require a calibration period, in which the pound and the stock market were positively correlated. One such period was the 3 months preceding the British EU referendum in June 2016. Shocking the GBP/USD exchange rate by -15% and using correlations from April 1 to June 23, 2016, results in the following returns for a choice of asset classes. All stock and bond returns are in local currency. Exchange rate changes are versus the pound.

The results show that a 15% GBP depreciation would correspond to a 12% plunge in UK share prices. This number is consistent with asset-class movements observed in the past. While the Dutch market could experience a similar drop, losses in Germany and France are projected to be slightly higher. Italian stocks show the biggest decline, which is not surprising given their recently increased sensitivity to political risk. The same is true for Italian government bonds, which, together with fellow-peripheral issuer Spain, are expected to suffer from a rise in risk premia over safer core sovereigns, such as France, Germany or the Netherlands. Contagion is also likely to spread to lower-rated corporate debt, although for investment-grade bonds the effect of lower risk-free rates would likely prevail. US corporate debt could even profit from a milder reaction of the American stock market. Gilts seem to be the biggest beneficiary, with a projected average gain of 6%. The Japanese yen can also be expected to benefit from repatriation flows, while the euro—though gaining against the pound—is likely to depreciate against other major currencies.

The above analysis was conducted using the Axioma Risk™ analysis platform.