Blog Posts — December 15, 2020

Stress-testing a ‘no-deal’ Brexit: much ado about nothing?

by Christoph Schon, CFA, CIPM

In the wake of failed last-minute talks between Britain and the European Union, both sides have now warned that a ‘no-deal’ Brexit is likely, despite a mutual commitment to continue negotiations. The pound is expected to take the brunt of any market reaction, but the impact on stock markets is less clear-cut. In this blog post, we present some suggestions on how to model a ‘no-deal’ outcome in a stress test. In most scenarios, we find the impact on share prices rather limited, perhaps suggesting that this particular outcome is, at least partly, already reflected in the underperformance of the UK stock market, compared with other regions.

Until quite recently, traders seemed fairly confident that an agreement between Britain and the European Union would be reached before the end of the transition period on December 31, propelling the pound to $1.34 on Wednesday, December 9. Yet, by the end of that week, the British currency was down 1.5% to $1.32, after signals from Prime Minister Boris Johnson that a ‘no-deal’ scenario was a strong possibility, following his unsuccessful crunch talks with European Commission President Ursula von der Leyen.

Assuming the deadlock continues and the transition period eventually expires without a trade agreement, it seems very likely that the pound will weaken further. In our proposed stress test, we assumed a decline of about $1.15—near the all-time low reached at the height of the pandemic in late March. From current levels, this would constitute a drop of around 14%, which would be similar in size to the depreciation observed in the three months following the original Brexit referendum in June 2016.

In our analysis described below, we performed a number of “transitive” stress tests on a global multi-asset class portfolio within the Axioma Risk™ platform. As suggested above, we applied a 14% downward shock to the GBP/USD exchange rate and derived the corresponding pricing-factor movements for the securities in the portfolio from betas and covariances calibrated over various three-month periods—the latter being the time horizon over which we expect these market moves to play out. The three calibration periods used in the analysis were chosen to represent different correlation regimes between exchange rates and share prices.

UK stock market versus GBP/USD

Source: Qontigo

The end dates for each correlation window are highlighted by the vertical dashed lines in the chart above. The first period—the three months ending February 21—represents the inverse relationship between pound and UK stock market prevalent for most of the time since June 2016. The second period—March to early June—reflects the extreme market turmoil at the height of the COVID pandemic, in which almost all asset classes were positively correlated. The numbers in the last column are based on recent asset-class interactions—ending on December 4—which constituted an environment of very low correlations. The table below shows the simulated returns of the British and European stock-markets and sovereign-bond benchmarks, as well as major currencies against the US dollar, for each end date and corresponding correlation regime.

Simulated asset-class returns for a 14% drop in GBP/USD

Source: Axioma Risk™

The worst-case scenario, with projected losses of around 16% in both the UK and Eurozone stock markets, is the middle one, calibrated through the worst part of the COVID crisis. This was, of course, an environment of extreme uncertainty—one in which “all correlations go to one”. However, market movements back then were driven by heightened concerns over the impact of the unfolding global pandemic. We would not necessarily expect this to be repeated in case of a ‘no-deal’ Brexit, which, in other parts of the world, might still be seen as a regional problem.

During the global stock-market rebound since the height of the pandemic in early March, the STOXX® UK 50 has been lagging significantly behind its American and many of its Continental European counterparts. Part of this was due to its large concentration in financial and energy companies, which have been among the worst performers year-to-date. But it could also indicate that much of the Brexit uncertainty is already priced in. This might explain the very small changes in share prices predicted in the recent, low-correlation scenario.

This does not necessarily mean that share prices will not change if there is no trade agreement, but rather that the outcome of the negotiations seems unlikely to have a major impact one way or the other. In other words, whatever happens to share prices is more likely to be due to changing prospects for a global economic recovery. Even in the first, pre-COVID scenario, with a negative correlation between the pound and the stock market, the impact on stock markets appeared to be rather benign. It is also in line with our earlier analysis of a ‘deal’ Brexit from July 2019, in which we simulated an appreciation to $1.43—the level which the pound had regained in early 2018, after initial successes in the early Brexit negotiations.

It is interesting to note, however, that the yen was expected to depreciate against the dollar in all three scenarios. Normally, one might expect the JPY to benefit from turmoil in other parts of the world, as Japanese investors tend to be very risk averse and repatriate their funds when things go awry elsewhere. However, during the initial market selloff in early March, the US dollar seemed to usurp the top spot as the world’s number-one safe-haven currency from the yen.

In our view, the last scenario, with low correlations between the pound and the UK stock market, and little impact on the latter, appears to be the most likely. However, stress-testing an “all correlations go to one” environment can still be useful for those trying to get a handle on a plausible worst case.