Published: 30 September 2019
When it became clear that the UK government was stepping up planning for a potential 'no-deal' Brexit it wasn’t investment markets that took a sharp dive - it was the pound.
The pound dropped to a two-year low against the US dollar when newly appointed Prime Minister Boris Johnson claimed in July that the government was “turbo-charging” preparations for a no-deal Brexit on 31 October. 1
The same day saw the FTSE 100 bounce higher, with the contrast echoing the immediate aftermath of the EU referendum in June 2016. On that occasion the pound plummeted to a 31-year low on currency markets.2 The FTSE also fell sharply in early trading it but it quickly recovered lost ground.
While the pound has never returned to its pre-Referendum level, stock markets - the FTSE 100 in particular - have remained largely resilient throughout the Brexit saga.
And as it happens, one reason for this is those movements in currency markets. That’s because around 70% of companies listed on the FTSE 100 - the UK’s blue-chip stock exchange - derive most or all of their earnings from outside the UK, typically reporting their profits in US dollars.3
This means that when the pound weakens, those dollar revenues are worth more when they are converted back into pounds, boosting the profitability and so the value of those companies (and therefore the index too).4 For converse reasons, when the pound strengthens the FTSE 100 would usually be expected to slow down.
A weaker pound can be good news for UK exporters too, as it makes UK-produced goods and services cheaper for non-UK customers and companies to buy.
Those factors could help explain why, even as negative economic news emerged in early September, stocks such as AstraZeneca, Diageo and Experian hit record highs.5
Crucially for long-term investors, the proportion of FTSE 100 members that declare large chunks of their earnings in US dollars include some of its biggest names, such as Royal Dutch Shell, BP, Glaxosmithkline and HSBC.6 The same firms are also staples of many large income-focused equity funds, due to their track record of paying out regular and growing dividends. Remember, though, that past performance is not necessarily a guide to future performance.
Those four companies also happen to be the biggest FTSE 100 constituents in terms of value, accounting for around 30% of the index’s entire market capitalisation. So when their shares are rising in value due to a weaker pound, they can have a disproportionately significant effect on the index as a whole.7
All of that makes for a very strong correlation between currency values and the fortunes of stock markets. And with the prospects for a deal vs no-deal Brexit outcome seemingly changing by the week, it’s a sensible factor for investors to keep an eye on. Analysts predict that while the pound/dollar rate could leap to $1.33 in the event of a Brexit deal, it would slump to $1.10 on a no-deal exit, a recent Bloomberg survey found. 8
The outcome, whatever it is, will likely have an influence on Central Bank decision making too. With interest rates already low at 0.75% the Bank of England has little room for manoeuvre if it wants to use cuts in the rate to bolster the economy should a no-deal Brexit happen.
In fact, it’s possible that any post-Brexit dip in house prices - Bank of England governor Mark Carney has warned that house prices could fall by up to 35% over three years in a worst-case scenario - could push the pound lower and force the Bank to consider increasing interest rates. 9
Similarly, further weakness in the pound could push up the cost to UK consumers of buying products and services from overseas, with a resultant increase in the rate of inflation that could again put pressure on the Bank to raise interest rates rather than cutting them.
Ultimately, political factors aren’t alone in influencing policy on matters such as interest rates, with inflation, wage growth and consumer spending levels among the main indicators.
Other global events can have a say too. Mario Draghi, the president of the European Central Bank, recently pointed out that its weaker economic forecasts did not factor in the possibility of a no-deal Brexit or the possibility of further global trade disputes (such as those between the US and China). 10
Whatever happens in the end, the correlation between currency movements and markets is clear, as is the role played by Central Bank policymakers. With so much uncertainty around, however, it would take a brave investor – and one who is willing and able to take the potentially significant risks involved - to make decisions based on predictions for possible currency movements as events unfold over the coming months.
Recent history shows that it’s very difficult to guess with any kind of precision what the short-term impact that economic and political developments will have on investments, let alone understand the full likely long-term implications.
Which for most investors brings things back to a simple, familiar but important message in uncertain times - be patient, keep your eye on the long term and reduce your vulnerability to market turbulence where you can by making sure your portfolio is sufficiently diversified across different assets and markets.
This is provided for general information only and takes no account of personal circumstances. It is not a recommendation to buy or sell. It is provided solely to support you in making your own investment decisions. If you have any doubts as to their suitability you should seek expert advice. Alliance Trust Savings does not give financial or investment advice.
Please be aware that the value of investments can fall as well as rise so you could get back less than you invest.
1 Independent - Pound slumps to new two-year low as no-deal Brexit fears intensify - 29 July 2019
2 Guardian - Pound slumps to 31-year low following Brexit vote - 24 June 2016
3 Shares - Why sterling's meltdown could get worse and what that would mean - 8 August 2019
4 City AM – Brexit three years on: markets and the economy in six charts – 24 June 2019
5 Bloomberg - Brexit Tumult Makes FTSE 100 a Winner as Negative Link Deepens - 2 Sept 2019
6 Guardian - No-deal Brexit: your financial survival guide - 3 Aug 2019 - section 5
7 Proactive Investors - Why the FTSE 100 is not the UK’s economic bellwether - 10 April 2019
8 Bloomberg - Carney Says Brexit-Hit Pound Looks Like Emerging Market Currency - 10 Sept 2019
9 Independent - No-deal Brexit may force interest rate rise, says Bank of England governor Mark Carney - 14 September 2018
10 Reuters - ECB Draghi - Weaker forecasts don't account for risk of hard Brexit - 12 Sep 2019
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