Failed negotiations on the terms of the UK's departure from the European Union (EU) could see globally diversified equity portfolios lose as much as 11%.
Meanwhile, a globally diversified multi-asset portfolio (60% allocation to equity and 40% to fixed income) could see as much as 7.8% lost within a year of Brexit concluding, according to analysis by MSCI.
Ahead of Article 50 being triggered on 29 March, MSCI conducted stress tests on the various potential outcomes of the negotiations. These included a hard Brexit, where negotiations fail completely, a ‘smooth' Brexit with trade deals concluded, and rising anti-EU sentiment gripping other EU nations.
Across all scenarios, the firm predicted globally diversified equity portfolios and fixed income portfolios would drop in value.
In a scenario where the UK fails to conclude new trade agreements with EU nations and has to rely on the World Trade Organisation, as well as Scotland breaking away from the UK, the pound could tumble a further 16% against the dollar and the euro.
The risk of default for the UK's sovereign debt could increase 10-year gilt yields by 10 basis points (bps), while European yields could rise by 60bps. Corporate credit spreads may widen, deepening systemic risk, and cyclical equity sectors could lose 12%.
Vice president of risk and regulation research Thomas Verbraken painted a negative picture of the potential global effects of such a scenario.
"This scenario envisions the UK being unable to conclude new agreements and customs rules with its major trading partners within the two-year period," he said. "A failure to negotiate trade pacts leaves the UK isolated in the WTO and produces a wave of uncertainty in global financial markets.
"Over the year that ensues, the UK experiences net outflows of talent, capital and foreign direct investments, while investment and spending slow. Investors price a deflationary recession into UK assets that generates spill-over effects worldwide."
On the other hand, in a situation where anti-EU sentiment grows across the continent with political parties such as the French National Front and the Alternative for Germany gaining power, the firm argues there could be "a Brexit that benefits the UK". This would be due to investors using the UK as an "island of safety" thanks largely to its bilateral trade agreements with the US and China.
The pound could rally by 16% against the dollar, while UK equities gain 4.2% and 10-year bond yields rise 10 bps. As a result, a diversified global multi-asset portfolio could gain 3.5%.
However, other portfolios would still lose value, with a risk parity portfolio dropping 3% and globally diversified fixed income portfolios losing 2.2% on average.
In a smooth Brexit scenario, the value of the pound would change little, while a 10-year UK bond would yield an additional 120bps.
Meanwhile, a globally diversified multi-asset portfolio could lose 1.6% of its value, while an equity-only globally diversified portfolio could fall 2.3% on average.
"This scenario envisions investors gaining confidence that the UK will forge trade agreements with the EU but that the pacts provide fewer benefits than the UK enjoyed previously," predicted Verbraken.
"Spending by the government and weakening of the pound boost expectations for inflation. Though the UK diversifies its trading partners in the long term, the country endures a bout of stagflation initially."
However, MSCI stepped back from predicting the eventual outcome of the negotiations.
Negotiations on Britain's departure from the EU kick off on 29 March with the process taking a maximum of two years.
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