Brexit Scenarios for Market Risk 2016

Author: Dr. Laurence Wormald, head of research and quants,
APT, FIS

Executive summary
The U.K. referendum on June 23, 2016 will have a profound impact on Britain’s relationship with the rest of Europe, and it could also provide a significant shock to securities markets, particularly if the vote is to leave the EU. In this brief note we focus on the potential scenarios for equities, FX, rates and credit markets associated with a leave vote.

Scenario analysis is an essential part of market risk management for the buy-side, and we believe that the exercise of estimating shocks, to both levels and volatilities for the most important factors driving risky securities markets, can provide vital insight into the exposures and potential losses of any fund. The FIS APT multi-asset class factor risk model is a powerful tool for risk managers when designing scenario analyses, since it encodes historical market information about correlations between observable factors and is designed to separate the signal from the noise when reporting on portfolio risk measures.

We have considered two “Brexit scenarios” – one in which a leave vote does not fundamentally change the political balance within Europe, and another (which we call “exit contagion”) in which a U.K. leave vote leads quickly to calls from powerful anti-EU parties across Europe for a process of re-negotiation with the EU under the threat of referenda, similar to that followed by the U.K. Other anti-EU parties may not be the governing parties at present, but they can claim sufficient popular support to destabilize their domestic politics in ways that will upset the markets.

The size and direction of the shocks set out in this note (see Table 1 below) are estimates based upon economic and market analysis from many sources, coupled with analysis of historical events viewed via the prism of the APT factor risk model.

The estimates suggest that asset managers should be paying very close attention to the significant risks associated with the U.K. referendum, and should be considering a variety of diversification and hedging strategies if their mandates permit them.

Time horizon
Many of the studies of the economic effects of the U.K. leaving the EU have a time horizon of many years, and focus on prospects for GDP growth, productivity, inflation and the trade balance rather than the way in which these changed expectations will affect securities markets in the short term around the time of the referendum itself. For example, the analysis by the OECD concludes that “Assuming fixed interest rates […], U.K. GDP growth would be reduced by 0.5 percentage point in both 2017 and 2018. The onset of the trade shock in 2019 adds to these costs considerably, with GDP growth reduced by 1.5 percentage points that year.”

Market risk managers need to create scenarios over these shorter time frames, and users of the APT risk management system tell us that the most useful time period for their purpose is “weeks to months” after the event day.

Among the sources we have consulted (see selected references below) only a few have taken this shorter-term view, notably the Bank of England, the ECB, Fitch Ratings, and the Blackrock Investment Institute.

Fitch has stated that “The inherent uncertainty about the implications of a leave vote may add to financial market volatility and result in a sterling depreciation”. Blackrock has concluded that “We see volatility in U.K. and European assets rising ahead of the referendum […] An actual Brexit would hit global risk assets, we believe, whereas a vote to stay would reassure markets. Sterling is most vulnerable to Brexit fears as it is the most liquid U.K. financial asset”. The Blackrock report also states “A leave vote would likely increase gilt yields. Portfolio inflows could falter, pressuring domestic sources of funding for the budget deficit. We could see bank funding costs rise and credit spreads widen. The Bank of England (BoE) would likely cut rates in such a scenario or revive quantitative easing, looking past any temporary rise in inflation caused by a weaker currency, we believe”.

It is clear that the scale of shocks would be very dependent on the policy response of central banks. In a recent article in the Financial Times, the economics editor Chris Giles has called on the Bank of England to set out clearly what its policy response would be, given that the Governor Mark Carney has stated that the possibility of Brexit represents the “biggest domestic risk to U.K. financial stability.” But so far the Bank has not provided this detailed guidance.

Shock estimates
It is important to note that we are not attempting to provide a definitive forecast, or even a probability, of a leave vote result in the U.K. referendum of June 23, 2016. The analysis presented here is designed to help risk managers by providing them with an economically motivated and risk factor-driven framework for assessing market risk in the event of such a result occurring.

For the purpose of this analysis, we have utilized the global multi-asset-class APT factor risk model which is designed to provide estimates of volatility and correlation for many hundreds of market rates, indices and other market factors (which we call “explanatory factors”) with a time horizon of weeks to months.

We can characterize the most important shocks for investors associated with a “leave” decision at the referendum by estimating the scale of shocks to equities, FX, rates and credit markets. In this note we have attempted to estimate the shocks to several of the most important rates and indices, which can all be considered as explanatory factors within the APT risk modeling environment. Because all risk estimates are based on distributions of future outcomes, scenario results are defined in terms of the expected shock to levels (typically affecting P&L) and to riskiness (typically affecting volatility and value-at-risk VaR)) which investors will experience in that scenario.

As part of the analysis, we have attempted to estimate the scales of the expected shocks by looking at historical scenarios from the last 15 years, although none of those scenarios can be considered to be very similar to the Brexit scenario.

The aim has been to utilize the existing historical scenarios, dating back to the 1990s, as a guide to the model-driven aspects of forward-looking scenario analysis, while using the genuinely new information only now becoming available to market participants as a guide to the likely ways in which this scenario is different from other crises and periods of market turbulence.

We have also considered a potential scenario (which we have called “exit contagion”) in which a Leave vote in the U.K. encourages other anti-EU parties in Europe (such as the Freedom Party in Austria, the Law and Justice party in Poland, or the Front National in France) to agitate more forcefully for re-negotiation or exit referenda in their countries. Political shocks are by their nature very difficult to forecast, so the uncertainty around the exit contagion shock estimates is even greater than that associated with simple Brexit.

Table 1: Brexit scenario shocks – “weeks to months” view from the event date

Simple Brexit
Exit contagion
Explanatory factor
Shock to level
Shock to volatility (relative to base)
Shock to level
Shock to volatility (relative to base)
 
 
 
 
 
U.K. equity market
-15%
+60%
-20%
+80%
U.K. financials
-18%
+80%
-25%
+100%
GBP 1-yr rate
+50bp
+100%
+75bp
+125%
GBP 10-yr rate
+100bp
+80%
+150bp
+100%
 
 
 
 
 
USD/GBP FX rate
-12%
+60%
-18%
+100%
EUR/GBP FX rate
-15%
+60%
-5%
+100%
 
 
 
 
 
Euro-ex U.K. equity market
-8%
+40%
-15%
+100%
Euro-ex U.K. financials
-10%
+60%
-20%
+125%
EUR 1-yr rate
+25bp
+50%
+75bp
+100%
EUR 10-yr rate
+50bp
+40%
+150bp
+80%
ITRAXX crossover
+150bp
+60%
+400bp
+125%
 
 
 
 
 
U.S. equity market
-5%
+40%
-10%
+60%
U.S. financials
-8%
+50%
-15%
+80%
USD 1-yr rate
-8bp
+50%
-15bp
+80%
USD 10-yr rate
-20bp
+40%
-40bp
+60%
CDX NAHY
+125bp
+50%
+200bp
+80%

Selected references

There is a very large and growing list of publications on Brexit and its possible consequences. This is just a short selection of starting points.

Bank of England
EU Membership and the Bank of England, October 2015

Blackrock Research
Big Risk, Little Reward: The UK Referendum on Europe, February 2016

The CityUK
Analysing the Case for EU Membership: How Does the Economic Evidence Stack Up? April 2014 (see especially Table 7: Summary of the economic impact of EU exit for different interest groups ECB)

Foreign Exchange Contact Group
https://www.ecb.europa.eu/paym/groups/pdf/fxcg/2016/0218/2016-02-18_summary.pdf

Bond Market Contact Group
https://www.ecb.europa.eu/paym/groups/pdf/bmcg/2016_BMCG_work_programme.pdf

Financial Times Brexit Hub page
http://www.ft.com/eu-referendum

Fitch Ratings
Brexit: Short-term Disruption for Most Sectors, Significant Longer-term Risks, February 2016

OECD
The Economic Consequences of Brexit: A Taxing Decision, April 2016