An exchange rate is not only a barometer of the economy but the stock markets as well, however, it is very difficult to figure out any single event or reason for the fluctuation in the exchange rate and its consequence on the stock indices. There has been a general trend that whenever Sterling Pound falls, the FTSE 100 tends to rise. In the below-mentioned five-year comparative chart of FTSE100 vs Pound, we can see that, whenever sterling Pound has fallen (vs US dollars in our case), the broader equity benchmark of the UK, the FTSE 100 index has risen and vice versa. Here we are going to analyse why does FTSE 100 rise when currency traders are pulling down the sterling pound?
5-Year FTSE100 vs Pound comparative chart. (Source: Thomson Reuters)
One of the major reasons for the inverse relationship between the FTSE 100 index and Pound can be termed the overseas earnings of the corporations. As it is a widely known fact that the FTSE 100 constituents are not just UK stocks, but they are more of global stocks, as the majority of the benchmark index constituent companies receive a large share of their earnings from the overseas market and their top line is widely diversified. Majority of these corporations are well known global companies, holding a substantial amount of market share in their respective operating area. This is why they are more of global stocks listed on the London bourse.
Primarily these companies use US Dollars as a reference or trading currency, and that’s why whenever Pound weakens against the US Dollar, it increases the value of those overseas earnings when repatriated back into sterling. That led to an increase in their share prices and the expansion in the FTSE 100 index as well as it represents a basket of these globally diversified businesses.
The FTSE 100 index is considered a benchmark index of 100 large companies of the United Kingdom by market capitalisation; however, it is majorly a basket of 100 large globally diversified companies, whose constituents source a majority of their revenue and earnings from the global market. Therefore, any weakness in the Sterling Pound will boost the sterling value of these companies’ earnings and that will lead to the increased bottom line and share price as well.
Nowadays, the FTSE 100 companies hardly represent the British economy in the same way as FTSE 250 or FTSE All-Share represents, as they are widely diversified and represent global economic health rather than of the UK only.
How FTSE 100 rises in the wake of a falling Sterling?
Let’s say an FTSE 100 constituent company gets the majority of its earnings from the United States, and it generates $100 m as annual profit. When they repatriate their overseas earnings into home currency at £/$ rate 1.25, these earning will become £80m, and if suppose Sterling starts falling and standing at £/$ rate of 1.10, it will increase the company’s earnings value by 22.7% to £90.0m. Therefore, as sterling plummets against the US Dollar, it will increase the value of a company’s earnings, when repatriated back to the home country.
The negative relationship between the FTSE 100 index and Sterling is also true, the stronger the pound is against the US dollar, it will put pressure on the FTSE 100 index. Let’s say at £/$ rate of 1.30, this will cost overseas earnings of the FTSE 100 companies, as at this exchange rate earning value of the company will stand at £76.9m.
However, the relationship between the UK’s broader index and the Sterling Pound is complex by the fact that a decline in the Pound will lead to increase in the import costs for the UK companies, also it reflects that the overall health of the economy is deteriorating something to which share price cannot sustain for a longer period. Therefore, one should be aware of the fact that FTSE 100 stocks will provide you with international exposure much larger than any other index. If one is invested in the global stock, directly or through super funds, they need to be aware of the impact of currency movement and should be aware of how to manage it. Lastly, the stereotype that whenever Sterling falls, FTSE 100 rises, is not 100% true, as one need to pay further attention to the global market and other macroeconomic and microeconomic events.
Let’s understand what makes currencies move
Forecasting currency movement is full of risk in the short term, as an economic data prevails or a thunderbolt political event may occur, which in general is difficult to predict, and that could take the currency to slip or surge in the short-term. But in the medium or long term, there are many strong drivers to predict the exchange market trends.
Normally, a stronger economy implies a stronger currency as global investor’s confidence rises towards the economy and they become more interested in buying assets in the country, which is denominated in that currency, which leads to increase the demand of that currency, which makes it move up.
Also, currencies are very much sensitive with the interest rates; higher interest rate implies a higher yield on those assets, which makes them lucrative from an investors’ point of view. Further, the trading relations of the country with the rest of the world also impact currency value, like the export-oriented economies which export more than import will typically have stronger currencies, driven by the demand for their products.
July 2019 UK GDP rise strengthened sterling
Sterling pound strengthened by higher than expected GDP growth rate in July, it surged firmly against the US Dollar in the September 09, 2019, trading session and touched the highest level of 1.2384 in the last one month after being critically exposed to the recent Brexit related uncertainties.
The data from the Office of National Statistics revealed that the country’s GDP recorded a growth of 0.3% in July 2019, driven by higher growth in the services after four consecutive months of muted growth.
At the time of writing on September 10, 2019 (before the market close at 11:03 AM GMT), the currency pair £/$ was trading at 1.2324 and was lower by 0.17% against the previous closing level. In the past one month the currency pair has registered a high of 1.2384 (as on September 09, 2019) and a low of 1.1959 (as on September 03, 2019), and in the year-ago period, its has registered a 52w high of 1.3385 and a 52w low of 1.1959 against the US dollars, and at the current trading level as highlighted above, it was trading 7.9% off from 52w high.
It fell below the crucial support level of 1.2 against the US dollar in the September 03, 2019 session amid heightened concerns for a no-deal or disorderly Brexit and the prospect of a snap election as well. On September 03, 2019, sterling touched its lowest level against the US dollar since 1985. However, the trend reversed afterwards following the British Parliamentarians passing a bill in the House of Commons to block a no-deal Brexit at any cost, as they assume that it is going to cost the British economy adversely.
However, steady Hosing prices in August 2019 followed by a boost in GDP growth in July 2019 has minimised chances of a recession in the UK. But still, the Pound will remain volatile until the Brexit deadlock gets resolved.