The science of sterling

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08/08/2018
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We are all far too aware of Brexit and many of the implications that we face with regard to leaving the European Union.

There remain deep disagreements within the UK Parliament and as the deadline looms, without agreement of fundamental issues like the Northern Ireland border and customs arrangements, there is a possibility of a no deal scenario which is putting the government under intense pressure. This is likely to have the biggest influence on sterling from day to day, along with world economic news and political tensions. As sterling weakens, the future profitability of companies with large overseas earnings rise and therefore their stock market valuations are also likely to rise. In the chart below it shows the relationship of the FTSE100 against the pound versus dollar since January 2016. I am sure you will note the move in the currency shortly after the referendum on 23rd June 2016 and the subsequent move on the FTSE100.

 

 

 

Normally, the weaker sterling becomes, the more the companies contained in the FTSE100 should see their earnings rise, leading ultimately to an increase in their share prices. The reverse is also true.

This is because such a large proportion of profits for FTSE 100 companies are made in dollars. If sterling weakens then dollar revenues, once converted back into sterling, are worth more. If the exchange rate was $2 to the pound, then every $1,000 of revenue would be worth £500. However, if sterling weakened and the exchange rate moved $1.5 to the pound, then every $1000 of revenue would be worth £667. The outcome is that revenues increased 33% as a result of the fall in sterling.

Around three quarters of revenues generated by FTSE 100 companies come from outside the UK. The strength of sterling against the euro is also important given the large chunks of revenue accounted for by France, Germany, Italy and other Eurozone countries. An example of an economic impact would be weaker than expected UK GDP data, triggering a slide in sterling and therefore pushing the markets higher. The view would be taken that interest rates would be less likely to rise if economic growth was weak therefore keeping more pressure on sterling.

One has to think that as the Brexit deadline nears, there will be more bouts of weakness, possibly caused by a lack of business investment and political uncertainty and therefore GDP growth or interest rates rising at a much lower rate than first forecast. This, with American rates rising, may well have the impact of a weaker sterling rate which will maintain the FTSE 100. Clearly the reverse is true and as America started to raise rates in the last economic upturn, it is notable that the dollar weakened which one wouldn’t have expected bearing in mind rates were increasing. Currency as we have noted in previous articles is notoriously difficult to predict and with so many impacts, it is clear that this is not an exact science!

 

 

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