Why There Isn’t a Perfect Inverse Relationship Between FTSE100 And Pound Sterling?

FTSE 100 index is a portfolio of 100 large-cap companies by market capitalization; also, the majority of these company’s revenue comes from abroad, primarily denominated in US Dollars. This often establishes an inverse relationship between FTSE 100 stocks and Pound Sterling. It means a surge in Pound Sterling against the greenback tends to drag down FTSE 100 stock’s profitability; as a result, stock prices start plummeting and vice-a-versa. Why is it so?

This is primarily related to foreign exchange translation effects; As aforesaid, majority of the FTSE 100 company’s earns their large chunk of revenue in US dollars; it means when they repatriate their revenues earned abroad to home country, due to currency translation effect, the foreign currency gets converted into more amount of Pound Sterling at a time when the home currency is weaker against that foreign currency; The companies, in this case, tend to earn more from currency translation.

For example, National Grid Plc (LSE: NG)- a multiline utility business headquartered in London, United Kingdom, earns the majority of its earnings from the United States. When it repatriates its earnings back to the UK at a time when GBP is softening against the US Dollar, it tends to boost their income in the United Kingdom.

Scenario 1. (GBP/USD = 1.30)

Let’s suppose, XYZ Plc- a FTSE 100 company-headquartered in the UK,  reported earnings in the United States for the FY2019 of US$500m, and at the time of currency translation GBP/USD exchange rate stood at 1.30, it means US$500m of profit reported in the United States will be £384.61m in the UK (GBP/USD = 1.30, therefore, US$500/1.30 = 384.61).

Scenario 2. (GBP/USD = 1.27)

At the GBP/USD exchange rate of 1.27, the US$500m of earnings reported in the United States would be £393.7m in the UK, and this reflects that the weakness in the home currency against the originating currency will expand earnings in the home country. It reflects that a weaker GBP against the greenback boosted earnings of the XYZ Plc in the home country.

Scenario 3. (GBP/USD = 1.32)

At the GBP/USD exchange rate of 1.32, the US$500m earnings of the XYZ Plc recorded in the United States for the FY19 would be £378.8m in the UK, which reflects that an appreciation in the home currency against the originating currency has dented XYZ Plc’s earnings in the home country. It reflects that a strong GBP against the US Dollar dragged down earnings of the XYZ Plc in the home country.

In the above example, it was clearly reflected that a weakening home currency against the originating currency tends to have a positive impact on the XYZ Plc’s profitability in the home country. And, higher earnings mean higher earnings per share, which will push XYZ’s stock price higher at the bourse. That’s why the market assumes that there is an inverse relationship between Sterling Pound and the FTSE 100 Index.

However, a continuous devaluation in the home currency against the foreign currency is not always a freebie for exporters or those who earn the majority of their earnings from the foreign country. A consistent fall of the home currency could raise a red flag against the current government because ultimately it is going to boost inflation in the home country and push input prices up for all economic entities, whether they are exporters of goods and services or importers. In the long-term, it will hurt both export and import businesses. Because even though exporters of goods and services earn higher through currency translation, inflated input costs could take out all the past gains and could inflate their expenditure bills which will lead to a lower profit including forex gains.

Since the Brexit referendum took place as on June 23, 2016, GBP has plummeted approximately 17.47% from June 23, 2016, closing of 1.4879 to 1.2279 (closing price as on September 30, 2019) against the US dollar. in the same period the broader index FTSE 100 bagged approximately 16.7% gains; however, despite a steep plunge in the sterling value, the broader index was not able to completely absorb the plunge in the sterling.

The Brexit saga has brought several structural problems in the British economy; it is highly expected that a no-deal kind of withdrawal agreement could drag British economy into recession; the implication is that it is going to impact both demand and supply, which indicates that even a higher forex gain for export-oriented FTSE 100 businesses would not be able to offset a  weaker or lower offtake of goods and services in the home country.

However, global economic growth is also struggling amid heightened trade spat between the world’s two largest economies, US and China, inflated trade tensions between Japan and North Korea, turmoil in the oil market post-sanctions imposed by the United States on Venezuela and Iran, and recent attack on Saudi Arabia’s two major oil facilities located in Abqaiq. These macro factors are denting the sentiments of the investor community and that is why safe-haven asset classes bagged decent gains for the past couple of months.

Therefore, despite a weaker sterling against the basket of major foreign currencies, the FTSE 100 would not be able to perform similarly to what it recorded since the Brexit referendum in 2016; global macro headwinds could weigh on the potential surge in the FTSE 100 index.

Market Levels

At the time of writing (as on October 01, 2019, at 11:58 AM GMT), broader equity index of the London Stock Exchange the FTSE 100 was trading at 7,379.09 and declined 29.12 points or 0.39% against the previous closing level, with stocks like FERGUSON PLC (FERG), NEXT PLC (NXT) and WHITBREAD PLC (WTB) are top performers on the FTSE 100 index, on the other side stocks like RECKITT BENCKISER GROUP PLC (RB), HARGREAVES LANSDOWN PLC (HL) and EVRAZ PLC (EVR) were the among the laggards on the FTSE 100 index, respectively. Other benchmark indices like the FTSE 250 index was quoting at 19,965.86 and gained 29.19 points or 0.15% against the previous closing level and FTSE AIM 100 index added 15.01 points or 0.34% to 4,468.30, respectively.

In the forex market, the British Pound was trading higher against the US Dollar at 1.2302 and Eurozone’s EURO quoting slightly below against the British Pound at 0.8863, respectively.

In the commodity market, the global oil benchmark Brent Crude trading approximately 0.9% higher at US$59.90/bbl, whereas US crude oil benchmark WTI Crude was quoting approximately 1% higher at US$54.66/bbl.