Seasoned investors would agree that forecasting exchange rate movements is difficult and potentially a risky strategy. Exchange rate movements depend on various, often unpredictable, macroeconomic factors.
In recent weeks it has found support, especially against the. But how can movements in the pound affect stocks in the and indices.
Pound Volatile Since 2016
A currency rises or falls against other FX peers. When headlines say the pound is weak, that weakness refers to other major currencies. The pound could depreciate against the US dollar while remaining stable against other currencies.
Following the outcome of the June 2016 Brexit referendum, the pound fell sharply. The value of the pound sterling against the US dollar went from about $ 1.47 to $ 1.22 in just five months after the vote.
Likewise, the early days of COVID-19 meant strength for the US dollar and weakness for the pound. On March 18, sterling fell below 1.15, a level not seen in decades. During the summer, however, the cable recovered. Now the rate is at 1.31.
After the Brexit referendum in 2016, the pound also fell sharply against other currencies, especially the. On June 22, 2016, the pound was about 1.30 to the euro. In November 2016 it was about 1.16.
At the end of March 2020, the pound fluctuated around 1.08 against the euro. The current rate is 1.11. So the recent gains in the pound are more a reflection of what we are seeing in the US dollar.
Different Effects of Currency Movements
Most of the companies trading on the FTSE 100 are multinational conglomerates. About three quarters of their income is generated abroad.
As such, a weak pound is not necessarily bad for sales. Put more simply, a devaluation of the pound would make British goods cheaper to buy, potentially increasing the amount of British exports in general.
When the pound falls, especially significantly, their sterling-denominated earnings increase significantly. The dollars and euros they earn outside of the UK will be worth more pounds, leading to greater profitability.
The inverse relationship is when the pound increases, as we have seen recently. Especially when the pound appreciates, the sterling-denominated profits of these companies decrease. The foreign currency they earn outside the UK is worth less in pounds, which could lead to a potential drop in profitability.
That said, a weaker pound also makes imported commodities more expensive. The increased costs are ultimately passed on to the consumer.
How FTSE Indices Respond
It is difficult to determine whether the " export effect" or "] dominates changes in costs," and whether investors respond equally to all companies on the FTSE 100.
Currency fluctuations, however, create a degree of uncertainty for investors. Analysts agree that a sharp downward move in the pound is typically good for the FTSE 100. For example, the index rebounded strongly weeks after the Brexit referendum. In about three months it was up about 10%. One of the drivers was probably the sharp fall in the pound.
As the pound weakened at that time, the US dollar and euro revenues of many FTSE 100 members, once converted back to sterling, became worth more.
Fast forward to the summer of 2020. Mainly due to the weakness of the dollar, the pound is now stronger against the US dollar and has been rising since June.
On the other hand, the FTSE 100 has been declining since mid-June. Part of this decrease may be due to short-term profit-taking. However, the strength of the local currency can also be a catalyst.
The effects of exchange rate fluctuations are generally less clear to the companies in the FTSE 250 index, as they tend to be more domestic-oriented. They are more directly affected by short-term developments in the economy and consumer confidence. In fact, the FTSE 250 has been trading in a range for the past three months.
Currently the UK and the EU are discussing a possible trade deal that would be acceptable to both parties, as part of the overall and ongoing Brexit-related divorce negotiations. FTSE 250 stocks are likely to benefit when the UK has more clarity on what the country's relationship with the EU will be like in 2021 and beyond.
The idea that increasing currency can hinder the local stock market typically applies to most markets. But the size depends on the index members' dependence on foreign income. The FTSE 100 is a particularly strong example of this dependence.
What Can the Average Investor Do When Currencies Spin? Keep calm and keep investing in good long-term companies regularly.
UK-based investors who are unsure of how to select individual companies due to the increased uncertainty that an industry may face can purchase a FTSE 100 or FTSE 250 tracker fund.
Non-UK investors looking to purchase FTSE 100 shares should consider purchasing a land-based buy.