Brexit And Its Impact On The Correlation Between Pound Sterling And FTSE 100

The Pound Sterling and FTSE 100 have enjoyed an inverse relationship since long. Whenever there is weakness in the British currency, most of the FTSE 100 companies enjoy better fortunes on account of higher sales resulting from currency translation. However, this trend has been broken this year with the FTSE 100 index having fallen 5.2 percent in the year to date and the British Pound reeling in a continuing downward spiral.

The FTSE 100, representative of the largest companies in the United Kingdom, in terms of revenues and market capitalization, is seen as the barometer of the British economy. Along with its twin, the FTSE 250, it is studied by economists, debt market makers and stock market professionals alike to carefully consider the implications of any unwarranted movements in this index. However, with the impact of the uncertainties posed by Brexit coming into the picture, it seems that it has broken down every relationship which the index had with other economically important parameters e.g. currency exchange rates, unemployment and consumer confidence to name a few.

Whenever there is a weakness in any country’s currency, it signals a high earning potential for the exporters of that country as well as other businesses dependent on these exporters. As a spiraling effect of this heightened activity businesses will borrow more money to fund their activities, which will again push up the currency demand and hence its value. This is a cycle that goes on in any economy unless it is impacted by some heavier economic phenomenon, which put the whole arrangement into disarray. Among such phenomenal forces are, government intervention to control exchange rates, war, severe natural calamity or something like Brexit.

Impact of Brexit on the British pound Sterling; With or without a deal Brexit will put the British economy in an adverse balance of payments situation. Under the European union treaty to which United Kingdom is a signatory, the country when exiting the union must compensate the union of its obligations for a certain future period, which in the present case of United Kingdom leaving the European Union comes to around £ 32.8 billion. This amount has to be paid compulsorily by The United Kingdom as part of the terms of the treaty and does not form part of any deal that may or may not take place between United Kingdom and the European Union. Add to it the amounts that may have to be paid should a deal be worked out between the two parties. In either case this huge flow of currency out of United Kingdom will put a heavy pressure on its balance of payments situation with the rest of the world, with the consequence that its currency will feel the heat for an extended period of time.

However, the impact of this weakened balance of payments situation on the British economy will be short-lived. With the fundamentals of the British businesses remaining the same, in the short run, exports will grow as it will be cheaper than before for outsiders to consume British goods, but imports will suffer as the country will find it dearer to purchase imported goods. In the long run however the earnings of the British people will improve, and their consumption levels will be back to where it was. The heightened business activities will, over time, compensate for the losses on account of the Brexit payments made to the European Union. So, in effect the currency and business activity cycle will become a little bit elongated.

The impact of the above on FTSE 100 will be little difficult to interpret. This time around a weakness in the currency is not impacting the fortunes of the FTSE 100 constituent companies in the same way it will do in a normal economic cycle. The reason for this is the change is the market landscape in continental Europe due to the impact of Brexit. Continental Europe is the largest market for British exports as well as the largest market from where it sources its inputs. In the past when the United Kingdom was a part of the European Union both parties enjoyed favorable trading environment which made goods and services moving to each other’s territories easy and cheap and a significant market had developed taking advantage of these relaxed conditions. However, now with these advantages disappearing into the history books, there is every risk that the business between these two blocks could shrink and the movement of goods and services could become constrained and expensive.  Hence, despite a weakening of the British currency, it exports will fall and input costs will increase more than proportionately because of real effects of systemically important economic factors.

Hence there are three factors that are critical to contain the impact of Brexit. Firstly, the payout to be made by the United Kingdom to European Union as part of this divorce deal (Brexit) must be contained to as minimum as possible. This will ensure that the recovery period will be small and harmful structural fault lines with not be able to break ground. Secondly, a push has to be provided to the British economy by providing greater liquidity to the British businesses which will ensure that the business cycles runs faster, hastening the recovery period. Thirdly, business opportunities lost due to Brexit, must be replaced with similar arrangements within economic blocks elsewhere which will ensure that the real business impacts on British companies are cushioned. The very idea of a departure from the European union for the British was based on the premise that European Union membership has not brought about as much economic advantages to the British people as was envisaged and that heightened trade with the rest of the world would be a better  alternative . As the country goes into Brexit at the end of October this year, this is the right time for them to test the premise.

With the above in mind the new British Premier Boris Johnson is scheduled to arrive in Paris this week to hold wide ranging consultations with the French president Emmanuel Macron and the rest of his cabinet. This will be followed by a similar trip to Germany where he will be meeting Chancellor Angela Markel. What he will pushing for is be a deal which will ensure a lesser cash payout and a softer real impact on the British economy. The importance of a with-deal Brexit is well understood by both sides, however no understanding has yet been arrived at by the two sides regarding the fallout of this mutual parting of ways with no deal. There has been a constant bickering between both the sides as well as with the British lawmakers regarding how the modalities need to be worked out. Several rounds of negotiations have taken place with very little progress, amidst increasing numbers of voices favoring a no-deal Brexit in the event that a deal is not worked out by the closing date. British Premier Boris Johnson, who is one of the proponents of the no-deal Brexit school of thought, had come to power by making it his primary commitment to honor the closing date under any circumstances.

The British premier has also planned similar trips to other parts of the world where he will be interacting with world leaders to secure suitable arrangements, which will cushion the impact of Brexit. However, there will be a rearrangement of business activity in the UK in any case which will have a medium-term impact on all parties concerned. How wisely and carefully the leaders from both sides walk the tight rope will determine the stability and sustainability of eurozone economies.

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