The early effects of the Brexit on the UK’s Financial market
Keith Meursing
Abstract
Using an event study approach, the impact of the Brexit vote on the UK’s financial market will be analyzed. The results show that the stock prices of the banking sector and financial service sector had a strong negative reaction to the Brexit vote. The other sectors showed mixed results. The results support the view that the banking sector and financial service sector will be affected the most following the Brexit, because these sectors are the largest beneficiaries of the EU. Results for the UK’s gilt market show that the change in yields decreased following the Brexit vote and all rating agencies downgraded the UK’s credit rating following the Brexit.
I.Introduction
On June 23 2016 the British government called for a referendum about a possible
withdrawal from the European Union. Of the participating voters, 51,9 percent voted for the UK to leave the European Union (EU Referendum Results, n.d.). This set in motion the
process of the British government to negotiate an exit from the European Union. On March 29 2017, Article 50 of the Treaty on the European Union was invoked by the British
government, meaning that the UK will leave the European Union on March 29 2019 (Wheeler, 2018).
The Brexit will have a large impact on the UK’s economy with spill-over effects for the rest of the EU (Kierzenkowski et al., 2016). The main argument for proponents of the Brexit is better immigration control, because free mobility of labor and immigrants will be abandoned (Hobolt, 2016). The Brexit will however have a large negative impact on the UK’s economy, because the UK will lose access to the European Single Market (ESM), the largest single market in the world (Breinlich et al., 2016). This will have a negative effect on the UK’s trading activity because the UK will have to trade under World Trade Organisation rules, which leads to higher trade tariffs and barriers (Kierzenkowski et al., 2016). This can be problematic because the EU is UK’s largest trading partner. The loss in exporting and
importing activity will have a negative effect on GDP. Part of this trading activity are also the Foreign Direct Investments (FDI’s). The FDI’s are also expected to decrease because of the higher trade barriers and forgone access to the EU’s Single Market (Breinlich et al., 2016). A reduction in FDI’s can have detrimental effects on innovation, productivity and GDP growth (Dhingra et al., 2016). The predicted effects of a reduction in FDI’s on GDP are larger than the effects from a reduction in trade activity (Breinlich et al., 2016). Inward FDI’s are expected to fall with approximately 22 percent (Breinlich et al., 2016).
A second important factor that will affect the UK’s economy is an increase in uncertainty. The outcome of the Brexit referendum was quite a surprise for most people and the leaders
(Hobolt, 2016). In the months after the Brexit vote it became clear that there was indeed no plan. The uncertainty about the future relationship between the UK and the EU is expected to affect the UK’s financial market (Baker et al., 2016). Investors will probably have less confidence and demand for UK assets and stocks because of an increase in volatility in financial markets and uncertainty about future policy developments (Kierzenkowski et al., 2016).
The cost of government financing may also increase (Baker et al., 2016). This comes from the fact that investors will hold less UK gilts if they expect that a Brexit will have negative
medium to long-term effects on the UK economy (Baker et al., 2016). Investors will then lessen the weights of UK gilts in their portfolio which will lead to a lower demand and subsequently higher borrowing cost for the UK government because the prices of UK gilts will decrease (Baker et al., 2016). This can be problematic because approximately 25 percent of UK gilts are held by international investors (Baker et al., 2016).
The forgone excess to Europe’s capital markets will also have a negative effect on the UK’s financial market, especially the banking sector and financial service sector, because these sectors are the largest beneficiaries of the Single Capital Union (Schoenmaker, 2017). It is clear from the previous examples that the Brexit will have a large impact on the UK’s economy and financial market. The implications of the Brexit for the UK’s financial market will be analyzed in this thesis, thus the research question is: What is the impact of the Brexit
on the UK’s financial market?
To answer the research question, the possible effects of the Brexit on the UK’s gilt market and stock market will be analyzed with special attention to the financial service sector and banking sector. The possible effect on the UK’s financial market will be analyzed, by looking at the theoretical framework and analyzing through which channels the stock market and gilt market will be affected. To analyze the reaction of the UK’s gilt market and stock market, an event study will be conducted. By conducting the event study for the UK gilt market, it is possible to analyze if there was a significant change in the gilt yields following the Brexit. The same method will be applied to the stock market, to analyze if there was a significant change in stock returns following the Brexit vote. When analyzing the stock market, there will be a special focus to the banking sector and financial service sector to analyze if these sectors where affected differently in comparison to other sectors of the economy.
The thesis has the following findings. Firstly, the results show that the stock prices of the banking sector and financial service sector decreased significantly, showing negative abnormal returns and negative CAR’s during the event window. These results hold for all event windows. This indicates a strong negative reaction to the Brexit vote. This conclusion does not hold for other sectors of the UK’s economy. These sectors include the Food & Drug Retail sector, Gas, Water & Multi-utilities sector, Oil & Gas sector, the Media sector, the Travel & Leisure sector and the Pharmaceuticals & Biotechnology sector. For the other sectors there were mixed results with some companies and industries showing a strong reaction to the Brexit vote and other companies not reacting or even showing positive abnormal returns. The Oil & Gas sector and Pharmaceuticals & Biotechnology sector showed positive abnormal returns for instance. The results for the UK’s gilt market show that the
change in yields on UK gilts decreased following the Brexit vote. This result holds for all gilts with different maturities.
The thesis is structured as follows. Section 2 will be dedicated to describing the importance of the UK’s financial market for the UK’s economy and the important role the City of London plays in European Finance. The third section of the thesis will be used to describe the
consequences of leaving the EU for the UK’s financial market. In section 4 there will be an in-depth analysis of the main channels through which the UK’s stock market will be affected following the Brexit. Section 5 will consist of an in-dept analysis of the main channels through which the UK’s gilt market will be affected. Section 6 is dedicated to take a closer look at the banking sector and the consequences the Brexit will have for UK banks. Section 7 describes the methodology and section 8 presents the results of the research. Section 9 offers the conclusions.
II. Importance of the UK’s financial market
The UK’s financial market has an important role in the world economy, with the City of London playing a central role. The City of London established itself as a global financial centre and the uncontested hub of European Finance. The City of London blossomed after the creation of the Capital Markets Union (CMU), a plan envisioned and implemented by the European Union (Lanoo, 2016). The idea was to create a Single Market with harmonized rules, where there would be only a single license needed to provide financial services and goods throughout the Euro area (Lanoo, 2016). The creation of the CMU allows firms to settle in the City of London and gain access to the European market with only a single license (Ständer, 2016).
Many renowned indices like ‘The Banker’s’ annual rankings or PwC’s annual ‘Cities of Opportunity’ rank the City of London in first place as the world’s best financial market. This comes from the unique role that the City of London plays in Europe’s capital markets. The City of London is not just a regular financial marketplace where only stocks are traded, but rather a financial wholesale market where many other financial services and securities are offered, including trading and clearing activities of currencies, equity, derivatives and government bonds for instance (Ständer, 2016).
The London Stock exchange is Europe’s largest stock market, with 479 foreign companies listed. The City of London is also a very popular location for banks to establish their
headquarters with over 358 banks located in the city (Lanoo, 2016). Especially large US and Swiss banks are settled in the city, with the five largest US-banks earning 92 percent of their turnover in the UK (Ständer, 2016). Furthermore, many insurance companies, institutional investors, hedge funds and specialized finance providers choose London as their home-base (Lanoo, 2016).
The financial sector is a large asset to the UK’s economy, contributing 11 percent of GDP and employing 2.2 million people according to TheCityUK’s report ‘Key Facts about the UK as an
international financial centre 2017’. TheCityUK reported that the UK’s financial sector is also
It is clear that the UK’s financial market is very important for the UK, and the implications of the Brexit should be analyzed extensively.
III. Leaving the EU
Leaving the EU would mean that the UK will probably lose access to the Capital Markets Union, because it seems very unlikely that the EU will grant the UK access to their capital market without the UK honoring the other freedoms of the Single Market (Ständer, 2016). The best-case scenario for the UK would be a ‘soft’ Brexit where the UK models their trade relationship with the EU after Norway. Norway is not a member state of the EU but is part of the European Free Trade Association, which means that they have full access to Europe’s Single Market. The only problem with this scenario is that the UK would still have to allow free movement of labor and make contributions to the EU-budget (Breinlich et al., 2016). It seems very unrealistic that the UK would accept these terms, because immigration control and restricting contributions to the EU-budget are the main arguments of the Leave
Campaign in support of the Brexit (Breinlich et al., 2016). It therefore seems almost certain that the UK will lose full access to Europe’s capital markets.
Losing access to Europe’s capital markets can have some serious implications for the UK’s economy and the financial market in particular. The UK will have to renegotiate their business relations with the EU to regain access to Europe’s capital markets. This will take years of negotiation and uncertainty for the UK’s financial sector. Even if the UK is able to reach a mutual beneficial deal with the EU, UK-licensed banks and firms will clearly enjoy much less freedom than they do now, because the single passport and freedoms of the CMU will be lost (Lanoo, 2016). If the UK is not able to provide a single passport to non-UK firms, a lot of these firms will have to relocate if they still want to have access to Europe’s capital markets. Between 15 and 30 percent of UK’s financial service activities would have to relocate to other countries of the EU according to early estimates (Ständer, 2016).
Because there is no clear plan in place about the future relationship between the UK and the EU, there is a lot of uncertainty about the future path of the UK’s financial market (Breinlich et al., 2016). This uncertainty and the forgone benefits of the Single Market will have a significant impact on the UK’s economy and different sectors of the financial market. Estimates of the Centre of Economic Performance (CEP) indicate a loss in GDP that ranges between 6 and 9 percent (Breinlich et al., 2016).
IV. Potential effects on stock market
The Brexit vote will likely have some serious consequences for the UK’s stock market. First of all, the uncertainty surrounding the future trade relationship with the EU and outlook of the economy will hamper investors’ confidence and delay firm investment (Kierzenkowski et al., 2016). The effect of uncertainty on firm investment has been studied by Leah and White (1996), Bloom (2009) and Bloom et al. (2014). They all reached a
consensus that uncertainty delays firm investment and hiring (Baker et al., 2016). Data of the OECD supports this statement by showing that investments declined by 2 percent in the last quarter of 2015, short before the Brexit referendum took place (Breinlich et al., 2016).
The OECD also conducted multiple surveys on the CFO’s of UK’s biggest companies. These surveys showed that there was an increasing risk aversion and uncertainty about the future business prospects which led to a decrease in hiring and investments (Breinlich et al., 2016). Because future growth of companies and GDP is dependent on investments, there was subsequently a decline in estimated growth rates of GDP (Breinlich et al., 2016). According to the assumptions of the Efficient Market Hypothesis, stock prices reflect all available information about companies and their future growth expectations (Fama et al., 1969). Based on these assumptions the UK’s stock market should reflect the decreasing growth opportunities caused by the decline in investments and it is therefore possible that there was a significant decline in UK stock prices following the Brexit.
Furthermore, it was shown that the financial markets started to price in the risk of the Brexit by lifting the risk premium (Breinlich et al., 2016). The bigger perceived risk could decrease investors demand for UK equities (Kierzenkowski et al., 2016). Lower demand for UK stocks will also lead to a decrease in stock prices and thus a decline in returns, but the increasing risk premium could possibly lead to higher returns. The effect of the bigger perceived risk on the UK’s stock returns is thus ambiguous.
So there are some factors that could lead to a significant decrease in stock prices and stock returns, for example the lower confidence and increasing uncertainty, which leads to a decline in firm investments, lower growth rates and lower demand for UK stocks. The higher perceived risk however, could lead to higher stock returns because of an increase in the risk premium. The uncertainty surrounding the Brexit could also lead to an increase in systematic risk, which should be reflected by an increase in the betas of British companies.
Although the increase in risk premium could lead to higher returns, the negative effect of the decrease in GDP, investments and growth rates will probably be stronger.
This makes it quite possible that the Brexit will lead to a decrease of the value of the UK stock market, and an increase in systematic risk and volatility until the future path of the UK becomes clear (Belke et al.,2018).
V. Potential effects gilt market
For the potential effects on the bond market, we first have to analyze how the government budget will be affected following the Brexit. The effect on the government budget will depend on two effects: the mechanical effect and the national income effect (Emmerson et al., 2016). The mechanical effect depends on the contributions the UK makes to the EU. In 2014, UK’s gross contribution was a hefty 18,8 billion pounds, which comes to 350 million pounds a week (Emmerson et al., 2016). This figure has been continuously brought forward by the Leave campaign as one of the main arguments in support of a Brexit. This number does not tell the whole story however, because the EU gives their member states rebates and subsidies out of the EU-budget. When the rebates and subsidies are taken into account, the UK’s net contributions are much lower. The UK’s net contributions are estimated to be around 275 million pounds a week (Emmerson et al., 2016). Thus leaving the EU could possibly save the UK government 275 million pounds a week if the future relationship with the EU would not include any fiscal transfers.
For the total effect on the government’s budget, the national income effect following the Brexit has also be taken into account. Because the savings of 275 million pounds a week, amount to approximately 0,8 percent of GDP, a national income effect that is negatively larger than 0,8 percent of GDP, would mean that government financing and subsequently government debt would increase if the UK’s government doesn’t make any fiscal
adjustments (Emmerson et al., 2016). As indicated earlier in this paper, the loss in GDP through is estimated to be between 6 and 9 percent (Breinlich et al., 2016). As John Van Reenen, Director of the Centre for Economic Performance, put it: ‘The amount we save from
paying less of an “entry fee” to Brussels is peanuts by comparison to these losses.’ So, we can
conclude that the government budget will undoubtedly be negatively affected following the Brexit.
The increased uncertainty surrounding the future of the UK, will also directly have a negative effect on the UK’s gilt market (Baker et al., 2016). Because of the increased uncertainty, foreign investors are expected to decrease their holdings of UK assets and UK gilts (Baker et al., 2016). This could be problematic, because approximately 25 percent of UK gilts are held by foreign investors. In the period leading up to the Brexit referendum, the demand for UK assets by foreign investors seemed to decrease. This view is supported by a large outflow of capital and subsequently a weaker sterling in the period leading up to the Brexit Referendum (Kierzenkowski et al., 2016). The sterling depreciated around 8 percent and analysis of the volatility of the sterling and correlations with news about the referendum proved that the weaker sterling was caused because of an increased risk attached to the sterling following the future of the UK (Baker et al., 2016). The decrease in demand and sales of UK gilts could lead to lower bond prices and subsequently an increase in the cost of government financing. The effect on the cost of government financing could be enhanced by a lower credit rating, because a number of rating agencies indicated that a Brexit vote, would lead to a
re-evaluation of the creditworthiness of the UK government (Baker et al., 2016). Based on the outlook of the UK’s economy and fiscal budget following the Brexit, a downgrade is a real possibility. This could be problematic because figures of the Bank of England show an increasing gross External debt since the first quarter of 2017. Based on the analysis of the effects of the Brexit on government financing and debt, there could be some significant effects on the bond market.
VI. Potential effects banking sector
The UK’s banking sector is one of the largest beneficiaries of the ‘single passport’ the
European Economic Area offers (Schoenmaker, 2017). The single passport gives UK-licensed banks access to Europe’s capital markets with their single UK-license (Ständer, 2016). This means that London based banks can provide services and capital to the Euro area, without the need of creating a subsidiary or attaining an individual license in the member states of the EU. Following the Brexit, the single passport would not be valid anymore and depending on future negotiations, UK banks could possibly lose full access to Europe’s capital markets. Losing full access to Europe’s capital markets could be detrimental to the UK’s banking sector, which is one of the most important sectors to the UK’s economy. Figures of TheCityUk show that the UK’s banking sector has the largest assets in Europe, with a total
value of 8 trillion dollars. The majority of these assets are held by the UK’s four largest international banks, which include HSBC, Royal Bank of Scotland, Barclays and Standard Chartered (Schoenmaker, 2017). The UK’s banking sector is also the global leader in cross-border bank lending, with 16 percent of the global market (TheCityUK). Approximately 50 percent of the UK banks operate as wholesale banks, which means that they engage in all trading activities, including derivatives. These activities take place in several currencies (Schoenmaker, 2017). So, the outcome of the future relationship between the UK and EU is very important for the UK’s banking sector, because they conduct a lot of business with the EU.
The possible downgrading of UK gilts, and decrease in bond prices will also have implications for the banking sector. Because banks hold a large part of government gilts in their portfolio, a downgrade on UK gilts and decrease in value would lower the value of their portfolio’s (Baker et al., 2016). This could lead to losses on their portfolio’s, which in turn would put pressure on the balance sheet of UK banks with large holdings of UK gilts. The possible reduction in portfolio values would also lead to a smaller part of their assets being available as collateral, which has implications for their ability to raise capital (Baker et al., 2016). This could lead to higher lending rates, which will affect private and corporate borrowing (Baker et al., 2016).
VII. Methodology
To test the reaction of the UK’s stock market and gilt market, an event study will be
conducted as proposed by MacKinlay (1997). An event study can be used to test the impact of a specific event on the value of a stock. The same approach is valid to measure the impact of a specific event on debt securities.
To conduct the event study, it is necessary to identify the event window first. This is the period for which the reaction of the stock prices and gilt prices will be analyzed. The Brexit referendum took place on June 23 2016. The results where clear late at night, so to consider the effect of the Brexit vote, June 24 2016 will be examined as the event date. There are multiple options to construct the event window. Three event windows will be used to add robustness to the results. The first event window will consist of stock data from 2 trading days before and 2 trading days after the event date. The second event window will consist of stock data from 5 trading days before and 5 trading days after the event date. The last event window will consist of stock data from 10 trading days before and 10 trading days after the event date.
The next step is setting up a market model to calculate the expected returns of the stocks and UK gilts. The market model that calculates the expected returns is determined by setting up an ordinary least squares (OLS) regression, where the actual stock and gilt returns from 252 days prior to the event window are regressed on the market returns. The formula for the expected return is:
where and are calculated by running the OLS-regression:
The standard error of the regression is calculated by:
The market model, has the assumption of a stable linear relation between the market returns and stock or gilt returns. It is now possible to calculate the abnormal return, by subtracting the expected returns, as calculated by the market model, from the actual stock returns. For the gilt market, the changes in yields will be analyzed. The equation for the abnormal return is:
Where ARi is the abnormal return in period ,Ri is the actual return measured by the actual
data in time ,which get subtracted by the expected return calculated by the market model. The cumulative abnormal return (CAR) is the summation of the abnormal returns in the event window. The formula for the CAR is:
where
1 is the first day of the event window and
2 is the last day of the event window. The abnormal returns will be jointly normally distributed under H0:with conditional variance
Because the abnormal returns are jointly normal distributed, the cumulative abnormal returns are also normal distributed under H0:
with conditional variance
Because of the properties of the OLS-regression and jointly normal distribution of the abnormal returns and CAR’s, a t-test can be performed to test for significant differences in returns following a specific event.
To analyze the effect of the Brexit on the stock market, data from 26 British companies across 8 different sectors will be selected. From the banking sector, the following 4 banks are selected: Royal Bank of Scotland, Barclays, Standard Chartered and Lloyds banking Group. 3i, Schroders, Standard Life Aberdeen, Hargreaves Lansdown and the London Stock Exchange Group are the 4 companies selected from the financial service sector. The
companies representing the Food & Drug retail sector are: Morrisons, Tesco and Sainsbury’s. Centrica, Severn Trent and United Utilities are companies from the Gas, Water & Multi-utilities sector. BP and Royal Dutch Shell represent the Oil & Gas sector. The media
companies are: Sky plc, ITV plc and WPP plc. The travel & Leisure sector are represented by: EasyJet, InterContinental Hotels Group and International Consolidated Airlines Group. The last sector is the Pharmaceuticals & Biotechnology sector. GlaxoSmithKline, Shire plc and AstraZeneca are the companies selected from this sector. Table 4 in the appendix provides a clear overview of the selected companies and sectors.
The market model will be constructed by running an OLS-regression, were the stock returns will be regressed on the returns of the market, 252 days prior to the event window. The FTSE 100 will be used as a proxy for the market returns. By setting up the market model, it is possible to calculate the expected returns for the event window and subsequently the abnormal returns and CAR for every company. The student t-test will be performed to test if the abnormal returns and CAR’s are significantly different from zero, to see if there was a significant change in stock returns following the Brexit vote.
In addition to the t-test for a significant change in the stock returns, there will also be a t-test performed to test if there was a significant increase in the systematic risk of the stocks. To test for a significant increase in the systematic risk, the Capital Asset Pricing Model (CAPM) will be used. The equation and properties of the CAPM are similar to the market model, only with some small adjustments. The CAPM uses an OLS-regression of the excess returns of a stock and the market instead of the normal returns. The CAPM also contains an additional error term, that measures idiosyncratic risk, so the beta in the CAPM only contains
systematic risk. Thus, an increase in systematic risk can be measured by testing for an increase in beta. The equation of the CAPM is:
where Ri is the excess return of the stock and Rm is the excess return of the market. Because the CAPM has the same properties as the market model, the betas are normally distributed under H0. Because of these properties, a t-test can also be used to test for a significant difference in systematic risk following the Brexit vote.
There will also be an event study conducted to test for a significant effect on the gilt market. The methods are the same, only for the Gilt market, the change in yields will be tested instead of the change in returns. The yields will be used instead of returns because the yields show the total return for holding a gilt till maturity.
To test if the change in yields was significantly different following the Brexit vote, a
regression will be run on the change in the market wide yields and the change in the yields of a gilt with a specific maturity. The market model that is constructed based on the regression will then be used to calculate the expected change in the yields. The abnormal change in the yields will then be the difference between the actual change in the yields that occurred during the event window and the expected change in the yields. A t-test will then be performed to see if the abnormal change in yields were significant following the Brexit vote.
The event study will be conducted for 7 UK gilts with different maturities: the 6-month UK gilt, 1-year UK gilt, 7-year UK gilt, 9-year UK gilt, 15-year UK gilt, 20-year UK gilt and the 30-year UK gilt. The iShares Index Linked Gilt Index will be used as a proxy for the market wide gilt yield.
In addition to testing for significant changes in the gilt yields, there will also be analyzed if the credit ratings changed following the Brexit vote. The credit ratings from Moody’s, Fitch and S&P will be used to analyze a possible downgrading of UK debt securities.
VIII. Data and empirical results
The event study performed for the stock market shows that the Brexit vote had a major impact on the stock returns. 20 of the 26 UK companies showed significant abnormal returns on the first trading day after the Brexit vote. When we compare the banking sector and financial service sector with the other sectors, we can clearly see that those two sectors where affected more fiercely by the Brexit vote. All the companies from the financial service sector show large negative abnormal return that are significant at the 1 percent significance level. The CAR’s for the companies of the financial service sector are also significant for all event windows, showing that the stock prices did not recover. The same result holds for the banking sector, with exception of Standard Chartered.
The stock returns from the other sectors show mixed results. From the other sectors, 6 out of the 17 companies showed significant negative abnormal returns and also 6 companies showed significant positive abnormal returns. These are mostly companies from the Oil & Gas sector and Pharmaceutical & Biotechnology sector. These two sectors reacted positively to the Brexit vote.
The data for significant CAR’s per event window show some form of robustness. For the 2-day event window, 6 out of the 17 companies showed negative abnormal returns and 7 companies showed positive abnormal returns. For the 5-day event window, 5 companies had negative cumulative abnormal returns and 9 companies showed positive cumulative abnormal returns. For the 10-day window, 6 companies showed negative cumulative
abnormal returns and 7 companies showed positive cumulative abnormal returns. Although the results are mixed per event window, it holds that the companies from the Oil & Gas sector and Pharmaceutical & Biotechnology sector, showed positive abnormal returns on the event date and positive CAR’s for most event windows. It is quite possible that investors shifted their investments towards these global industries that seem to have a far more inelastic demand and are less dependent on trade with the EU. The Travel & Leisure and Media sector also showed in general negative CAR’s per event window and negative abnormal returns on the event date.
Analysis of the beta’s show that 16 of the 26 companies had a significant increase in their post Brexit beta. The banking sector and financial service sector also showed the highest increase in post Brexit beta, with an average increase of 0,15 in beta. The Oil & Gas sector and Pharmaceutical & Biotechnology sector also showed the best performance in post Brexit beta, with an average decrease of 0,09 in beta. The empirical data seems to be supportive of the view that the banking sector and financial service sector will be affected the most
following the Brexit, because these sectors are the largest beneficiaries of the EU and in specific, the Capital Markets Union.
Table 1
Stock market reaction to the Brexit vote
Stock Sector AR CAR2 CAR5 CAR10 Beta pre Brexit
Beta post Brexit
Diff.
Morrisons Food & Drug Retails -0,86% -4,17%** -2,16% -9,85%** 0,86 0,92 0,06** Tesco Food & Drug Retails -0,11% -0,41% 5,28%** 0,13% 0,98 1,07 0,08** Sainsbury’s Food & Drug Retails -5,11%** -8,53%** -7,23%** -14,58%** 0,87 0,95 0,08** Centrica Gas, Water &
Multi-utilities
-2,75%* 1,63% 3,33%* 4,58%** 0,92 1,01 0,09** Severn Trent Gas, Water &
Multi-utilities
1,14% 3,33%** 3,34%** 3,01%** 0,648 0,654 0,006 United Utilities Gas, Water &
Multi-utilities
1,59% 2,75%** 1,79%* 1,49% 0,665 0,669 0,004 BP Oil & Gas Producers 5,90%** 7,31%** 9,91%** 12,89%** 1,32 1,22 -0,10** RD Shell Oil & Gas Producers 5,13%** 7,45%** 8,29%** 8,23** 1,30 1,18 -0,12** Sky Media -4,26%** -5,05%** -7,22%** -13,44%** 0,74 0,84 0,10** ITV Media -17,80%** -19,13%** -15,72%** -14,18%** 0,82 1,10 0,27** WPP Media -1,17% 1,27% -1,78% -1,32% 0,947 0,952 0,005 Easyjet Travel & Leisure -12,37%** -30,22%** -30,39%** -32,32%** 0,63 0,90 0,26** IHG Travel & Leisure 4,38%** 0,98% 1,93% 1,62% 1,01 0,99 -0,01 ICAG Travel & Leisure -19,49%** -28,76%** -25,62%** -32,38%** 0,98 1,25 0,27** GSK Pharmaceuticals &
Biotechnology
6,29%** 7,54%** 3,33%** 7,90%** 0,84 0,76 -0,08** Shire Pharmaceuticals &
Biotechnology
7,17%** 8,14%** 5,53%** 7,17%** 0,98 0,93 -0,05** AstraZeneca Pharmaceuticals &
Biotechnology
Stock Sector AR CAR2 CAR5 CAR10 Beta pre Brexit Beta post Brexit Diff. 3i Financial services -5,37%** -7,44%** 1,86% -7,48%** 1,11 1,24 0,13** Schroders Financial services -8,26%** -15,02%** -6,34%** -12,90%** 1,22 1,41 0,19** Standard Life Aberdeen Financial services -13,48%** -13,94%** -7,33%** -22,34%** 1,18 1,34 0,15** Hargreaves Lansdown Financial services -11,75%** -10,85%** -2,92%* -14,57%** 1,18 1,40 0,22** LSE Group Financial services -5,55%** -6,26%** -3,75%* -8,67%** 0,99 1,11 0,12** RBS Banking -14,35%** -27,87%** -29,93% -26,66%** 1,13 1,30 0,17** Barclays Banking -13,31%** -25,76%** -18,69% -24,98%** 1,36 1,56 0,20** Standard Chartered Banking 2,94% 0,28% 5,73%** 3,31% 1,70 1,65 -0,05* Lloyds banking Group Banking -17,81%** -19,70%** -18,49%** -27,57%** 1,01 1,25 0,25** AR: Abnormal return
Car2: Cumulative abnormal returns event window (-2, +2) Car5: Cumulative abnormal returns event window (-5, +5) Car10: Cumulative abnormal returns event window (-10, +10) *at the 5% significance level
**at the 1% significance level Source: investing.com
The event study conducted on the change in yields and rating of UK gilts show conclusive results. All UK gilts showed a significant decrease of the change in yields on the event day. UK gilts with shorter maturities showed the largest decrease of the change in yields. By looking at the CAR’s for all the UK gilts, we can see that the UK gilt market did not recovery during the event window, because every gilt had significant negative CAR’s during all event windows. This result shows that the yields decreased following the Brexit vote.
The results are not supportive of the view that the value of UK gilts would decrease following the Brexit. If this was the case, the change in yields would actually show an increase, which would lead to higher yields and subsequently a decrease in the value of UK gilts. It is possible that the lower yields and thus higher gilt prices are caused by a shift in investment from higher risk securities to lower risk securities like gilts. Investors tend to shift their investments to safer assets in times when the stock market is very volatile. The event study conducted on the stock market showed that the systematic risk increased significantly after the Brexit vote and the great uncertainty about the future path of the UK makes the stock market very volatile. Because the Bank of England acts as a lender of last resort, UK gilts are still very safe assets, even after the Brexit vote. It therefore would make sense that the demand for UK gilts increased following the Brexit vote.
The expectations about a lower credit rating however proved to be true. Moody’s, Fitch and S&P all re-evaluated the UK’s credit rating a couple days after the Brexit vote. Concerns about the future outlook of the UK’s economy, led to a lower credit rating by all credit rating agencies.
Table 3
Gilt market reaction to the Brexit vote
Gilt AR CAR2 CAR5 CAR10
6-month UK gilt -12,47%** -15,77%** -25,75%** -35,88%** 1-year UK gilt -21,33%** -36,73%** 12,72%* -12,64%* 7-year UK gilt -8,23%** -7,41%** -7,34%** -22,89%** 9-year UK gilt -5,18%** -4,60%** -1,19%* -17,16%** 15-year UK gilt -2,75%** -3,91%** -3,80%** -9,71%** 20-year UK gilt -2,25%** -4,07%** -3,69%** -8,45%** 30-year UK gilt -1,31%* -3,01%** -2,01%** -7,40%**
AR: Abnormal return
Car2: Cumulative abnormal returns event window (-2, +2) Car5: Cumulative abnormal returns event window (-5, +5) Car10: Cumulative abnormal returns event window (-10, +10) *at the 5% significance level
**at the 1% significance level Source: investing.com
Table 4
Credit rating following the Brexit vote
Agency Credit rating pre-Brexit period Credit-rating post-Brexit period
Moody’s Aa1 Aa2
Fitch AA+ AA
S&P AAA AA
Source: tradingeconomics.com VIIII.Conclusions
An event study was conducted to see how the UK’s financial market reacted to the Brexit vote. There was a special focus on the banking sector and financial service sector when analyzing the effect on the stock market. These sectors were chosen because of their importance for the UK’s economy and these sectors are also the largest beneficiaries of the EU. The creation of the Capital Markets Union and the single passport that comes with it, let the City of London blossom into Europe’s most important financial hub. Leaving the EU will therefore have serious consequences for the City of London. The results of the event study are supportive of this view. The banking sector and financial service sector reacted strongly to the Brexit vote, showing large negative abnormal returns on the first trading day after the Brexit vote. The CAR’s also show conclusive results, with large negative CAR’s. The large negative CAR’s are consistent for all event windows, showing that the market did not recover. The banking sector and financial service sector also showed the largest increase in their post Brexit betas.
Other sectors of the UK’s economy showed mixed results. It does seem however that industries that are less dependent on trade with the EU performed better. The Oil & Gas sector and Pharmaceutical & Biotechnology sector for instance showed positive abnormal returns on the event date and positive CAR’s for most event windows. The Media sector and Travel & Leisure sector showed negative abnormal returns on the event date and negative
CAR’s, but this does not hold for all companies. The effect of the Brexit differs per sector and company, so there is not a main conclusion that can be drawn from the data.
The event study conducted on the gilt market showed conclusive results. All UK gilts showed a significant decrease of the change in yields on the event day and the same holds for the CAR’s. The CAR’s are negative for all event windows, meaning that the UK gilt market did not recover and the decrease of the change in yields persevered. This means that the yields were lower than expected following the Brexit vote. This result is not supportive of the view that the value of UK gilts would decrease, which in turn would lead to higher yields.
Increasing demand for gilts because of a shift in investment towards safer assets might be a possible explanation for the lower yields. There was however a downgrading of the UK’s credit rating by all credit rating agencies following the Brexit vote. If the post Brexit
negotiations with the EU are not favorable for the outlook of the UK’s economy, a possible decrease of the value of UK gilts may still occur.
References
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Appendix
Table 4
List of selected companies per sector
Stock Sector
Royal Bank of Scotland Banking
Barclays Banking
Standard Chartered Banking
Lloyds banking group Banking
3i Financial services
Schroders Financial services
Standard Life Aberdeen Financial services
Hargreaves Lansdown Financial services
London Stock Exchange Group Financial services
Morrisons Food & Drug Retails
Tesco Food & Drug Retails
Sainsbury’s Food & Drug Retails
Centrica Gas, Water & Multi-utilities
Severn Trent Gas, Water & Multi-utilities
United Utilities Gas, Water & Multi-utilities
BP Oil & Gas Producers
Royal Dutch Shell Oil & Gas Producers
Sky plc Media
ITV plc Media
WPP plc Media
Easyjet Travel & Leisure
InterContinental Hotels Group Travel & Leisure International Consolidated Airlines Group Travel & Leisure
GlaxoSmithKline Pharmaceuticals & Biotechnology
Shire plc Pharmaceuticals & Biotechnology
AstraZeneca Pharmaceuticals & Biotechnology
Statement of originality
This document is written by Keith Meursing who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
