Recently in the UK, the Financial Policy Committee of the Bank of England (FPC), released its latest bi-annual Financial Stability Report (the Report), which sets out the views of the FPC on the stability of the UK’s financial system, and what it is doing to reduce or mitigate any risks to that stability. The Report includes a stress test, subjecting the system to shocks greater than what would be perceived to be normal. In particular, they examined the impact of Brexit, including what is being termed a ‘disorderly exit’ scenario.
Contrary to what one might expect, the market’s reaction to the Report has been decidedly negative. There has been, incorrectly in our minds, more focus on the Bank of England Governor Mark Carney’s comments rather than the report itself. In particular, the shock and horror reaction to the possibility of GDP growth shrinking by 8% within a year.
But what did the Report actually say?
On Brexit, the Report states; “The FPC has reviewed a disorderly Brexit scenario, with no deal and no transition period, that leads to a severe economic shock. Based on a comparison of this scenario with the stress test, the FPC judges that the UK banking system is strong enough to continue to serve UK households and businesses even in the event of a disorderly Brexit.”
On the stress test; “The 2018 stress test shows the UK banking system is resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the global financial crisis and that are combined with large falls in asset prices and a separate stress of misconduct costs.”
The Governor stated; “The Bank of England is ready for Brexit, whatever form it takes. The analysis released today confirms that the core of the UK financial system is resilient to worst-case Brexit outcomes. The bank has contingency plans in place to support institutional resilience and market functioning, if necessary.”
He also went on to say…”Let me begin by stressing what these analyses are and what they are not. These are scenarios not forecasts. They illustrate what could happen not necessarily what is most likely to happen.” What has happened here is that the bank used a worst case scenario in its stress test, which is two and a half times worse than the Brexit scenarios and it’s the results of the stress test that the market has focused on.
It is certainly possible for scenarios to unfold which are negative and as bad as what the Report considers. At this point the market has now essentially priced in a very poor scenario!
Sterling, until such time as a deal (or not) is fixed, will remain vulnerable. Further to this, we have the US Federal Reserve continuing to normalize monetary policy, meaning higher real interest rates at precisely the time that the UK is most vulnerable. In other words, from an FX point of view, this is about at bad is it is going to get. Given sentiment, risk appetite for sterling is likely to remain limited until details of the Brexit path are known.
We therefore think that at this point much of the bad news in the Report is already in the price, but more importantly, that the market reaction has been overly sensitive and even an overreaction. This is not to say that now is the time to take on UK risk, whether in the form of rates, FX, or equity risk, since as we stated, appetite for UK risk is likely to remain limited until clearer details emerge of the Brexit path.
In our Multi Asset Funds, we have remained underweight to both sterling and UK equity, and what little UK equity we have is in the form of optionality, thus protecting the downside.