Stress testing Brexit: Deal or no deal?

• 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.

Brexit has roiled markets after U.K. voters chose “leave” in the June 2016 referendum. Immediately, the pound plunged 8% against the U.S. dollar (as the exhibit below shows). Since then, Brexit has turned into a political thriller, as underscored by yesterday’s news that Downing Street considers a deal unlikely.¹ The pound is now 17% cheaper than prior to the referendum, and both U.K. and European equity markets have underperformed global markets. Our stress test suggests there is room for further losses if a no-deal Brexit occurs or — if a deal between the U.K. and European Union is struck before the Oct. 31 deadline — markets may rebound.² Depending on the outcome, the impact on the U.K. equity market may range from -15% to +10%, while the pound might lose 10% or gain 8% relative to the U.S. dollar.

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

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.

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®.

Further Reading

Brexit and the risks of home bias

Brexit home page