Seasoned investors would concur that predicting currency exchange-rate moves is difficult and, potentially, a risky strategy. Foreign exchange movements depend on several, often unpredictable, macro-economic factors.
In recent weeks, the pound has found support, especially against the US dollar. But how might moves in the pound affect shares in the FTSE 100 and FTSE 250 indices?
Pound Volatile Since 2016
A currency rises or drops relative to other FX peers. When headlines say the pound is weak, that weakness is in reference to other major currencies. The pound could drop in value relative to the US dollar, while remaining the steady versus other currencies.
Following the June 2016 Brexit referendum result, the pound fell hard. The value of sterling relative to the US dollar went from about $1.47 to $1.22 in just five months after the vote.
Similarly, the early days of COVID-19 meant strength for the US dollar and weakness for the pound. On Mar. 18, sterling plunged, falling below 1.15, a level not seen in decades. However, over the summer the cable rebounded. Now, the rate stands at 1.31.
After the Brexit referendum in 2016, the pound also fell sharply against other currencies, especially the euro. On June 22, 2016, the pound was about 1.30 to the euro. In November 2016, it was about 1.16.
In late March 2020, the pound was hovering around 1.08 against the euro. The current rate is at 1.11. Thus, the pound’s recent move upward is more a reflection of the weakness we are seeing in the US dollar.
Different Effects Of Currency Moves
Most of the companies that trade on the FTSE 100 are multinational conglomerates. Approximately three-quarters of their revenue is generated overseas.
As such, a weak pound isn’t necessarily bad for sales. Put more simply, a devaluation of the pound would make British goods cheaper to buy, potentially boosting the amount of UK exports overall.
When the pound falls, especially significantly, their sterling-denominated earnings rise considerably. The dollars and euros they’re earning outside the UK become worth more pounds, leading to an increase in profitability.
The reverse relationship holds true when the pound increases, as we have been witnessing recently. When the pound rises in value, especially significantly, the sterling-denominated earnings of these firms decrease. The foreign currency they are earning outside the UK is worth less in pounds, leading to a possible decrease in profitability.
That said, a weaker pound also makes imported raw materials more expensive. The increased costs eventually get passed down to the consumer.
How FTSE Indices Respond
It’s hard to pinpoint if the “export effect” or “changes in costs” dominates, and whether investors respond equally to all firms on the FTSE 100.
However, currency fluctuations lead to a degree of uncertainty for investors. Analysts concur that a significant downward move in the pound is usually good for the FTSE 100. For example, the index staged a strong recovery weeks after the Brexit referendum. In about three months, it was up about 10%. It is likely that one of the drivers was the strong decline in the pound.
When sterling weakened at the time, US dollar and euro revenues of many FTSE 100 members, once converted back into sterling, became worth more.
Fast forward to the summer of 2020. Mostly due to the weakness of the greenback, the pound is now stronger against the US dollar, moving upward since June.
On the other hand, since mid-June, the FTSE 100 has been declining. Part of this decline may be due to short-term profit-taking. However, the strength of the local currency may also be a catalyst.
The effects of exchange-rate movements tend to be less clear-cut for the companies in the FTSE 250 index as they usually have a more domestic focus. They’re more directly affected by the short-term developments in the economy and consumer sentiment. In fact, in the past three months, the FTSE 250 has been trading in a range.
Currently, the UK and EU are discussing a potential trade deal that would be acceptable to both sides, part of the overall and ongoing Brexit-related separation negotiations. FTSE 250 shares are likely to benefit when the UK has more clarity as to what the country’s relationship with the EU will look like in 2021 and beyond.
Bottom Line
The notion that an increasing currency may hinder the local stock market typically applies to most markets. But the extent depends on the reliance of the index members on foreign revenues. The FTSE 100 is a particularly strong example of this dependence.
What can the average investor do as currencies gyrate? Keep calm and carry on investing regularly in good companies for the long-run.
UK-based investors who are unsure about selecting individual companies due to the increased uncertainty an industry may face, could buy into a FTSE 100 or FTSE 250 tracker fund.
Investors outside the UK who would like to buy FTSE 100 shares may consider buying an exchange-traded fund that focuses on the country.