The pound’s down and FTSE’s up (again)… Are markets too complacent about Brexit?

  • The recent interplay of falling pound and rising FTSE is reminiscent of late 2017, when the first ‘breakthrough’ in Brexit negotiations was reached. This indicates that markets are now largely discounting an imminent departure from the European Union—in spite of government assurances and efforts to the contrary.
  • While remaining in the EU—potentially as a result of a second referendum—would presumably be the preferred scenario for financial markets, the associated participation in the upcoming European Parliamentary Elections bears substantial downside risks, such as the fact that the British contingent could be dominated by more extreme parties.
  • A stress test using correlations from the past 3 months confirms the similarities with 2017; namely that UK share prices rise when we shock the pound downward. Yet, in contrast to 2017, Continental European stock markets are exhibiting losses in the current environment, reflecting heightened recession concerns in France, Germany and Italy.

With less than 4 weeks to go before the European Parliamentary Election—the one that Britain was not supposed to take part in the first place—markets appear to be surprisingly unfazed by the potential ramifications of that vote. Despite the recent setbacks in the Tory/Labour Brexit talks, increasing calls for Theresa May’s resignation and the growing popularity of Nigel Farage’s new Brexit Party, the FTSE 100 index rose to a 6-month high on April 23. Combined with a weakening pound, this brings to mind the familiar pattern of “pound down/FTSE up”, which we observed over most of 2017. In fact, the negative correlation between share prices and exchange rates is almost as strong as it was when the first ‘breakthrough’ was reached in the withdrawal discussions with the European Union in December 2017.

Markets seem to discount an imminent exit...

This indicates, in our view, that traders are now largely discounting the likelihood of an imminent UK departure from the EU—despite what the British government would have them believe. Part of this may even be wishful thinking or the hope that Britain may not leave the European Union after all—perhaps because of a second referendum. Yet, while that would presumably be the preferred solution as far as financial markets are concerned, the fact that the UK would also have to participate in the European Parliamentary Election bears numerous downside risks.

...but participation in the European Elections bears its own risks

Many moderate candidates from the Conservative and Labour parties will struggle to earn their constituents’ votes, if they, at the same time, keep insisting that their tenure will only be temporary—if they take up their seats at all. At the same time, disgruntled citizens are likely to use this as an opportunity to express their discontent by giving their votes to more extreme parties, such as the Brexit Party. In fact, the most recent opinion polls see the latter in the lead, ahead of the Labour Party and the Conservatives. This bears the danger that Britain could end up being represented for the next five years by a group of MEPs who do not speak for the majority. And even if those representatives never take up their seats, the likely losses for the Conservative Party would be seen as a further indication of the lack of confidence in the Prime Minister and her cabinet.

Current correlations imply a UK share price rise when the pound falls...

A number of stress tests we performed on Axioma’s global multi-asset class model portfolio confirmed the present inverse relationship between the stock market and currency. Building on our earlier work on Preparing for a cliff-edge Brexit, we extended the range of calibration periods by including more recent correlations. Applying the same 15% downward shock in the GBP/USD exchange rate as in the original study—but this time using correlations from the 12 weeks ending April 19, 2019—we noted a 3.7% rise in UK equities. This is in contrast to the 12.6% drop in share prices, which was predicted when employing an environment where the interplay of pound and FTSE was positive, such as the 3 months preceding the June 2016 referendum.

...while Europe is hit by recession fears

Next, we compared the recent results with the correlation regime prevalent at the end of 2017, when the first ‘breakthrough’ had been achieved on the withdrawal agreement from the European Union. We noted a similar rise of 4.5% for British stocks for the same 15% GBP depreciation. Yet, while other European countries would still have profited alongside the UK equity market back in 2017, the picture is very different under more recent correlations. German stocks, in particular, show a projected loss of almost 3%, which reflects current recession fears in the manufacturing sector of Europe’s largest economy.

Gilts and yen profit from flight-to-safety

In all three scenarios, Gilts were the biggest beneficiaries. German Bunds also profited from their safe-haven statues, although the sizes of the gains seemed to depend on the levels of risk aversion, symbolised by the corresponding stock-market losses. Italian government bonds, on the other hand, recorded negative returns throughout, as that country’s assets have recently been very sensitive to political risk in general. The yen usually tends to benefit strongly from repatriation flows, in times when things are going badly in other parts of the world. The euro also rose against the pound, though by less than the assumed 15% US dollar appreciation, implying an effective weakening of EUR/USD.

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Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.