Since the EU referendum result, the pound has fallen and the FTSE 100 has risen. This may seem counter-intuitive since the FTSE 100 is the UK’s largest share index and the pound is obviously the UK’s currency. However, there are clear reasons why their performance has diverged and why the situation could continue over the medium term.
The pound is currently trading at £1 = $1.275. This is its lowest level in over a decade and there are two main reasons for it. The first is uncertainty regarding the outlook for the UK economy. With Brexit looming, the Bank of England has slashed its growth forecasts. It now expects the UK economy to grow only slightly in 2017 and unemployment to rise by 0.5% over the medium term.
Uncertainty could increase significantly when the UK government invokes Article 50 of the Lisbon Treaty next year, with a two-year negotiation period to follow. Then, once that is completed, the UK will finally go it alone as an independent state which is no longer in the EU. This could prove to be the most uncertain period of the lot and the pound could come under further pressure.
The second reason for the pound’s weakness is interest rates. Since the EU referendum the Bank of England has halved the base rate to 0.25%. This fall in the interest rate has the effect of weakening a country’s currency. The Bank of England has also indicated that further falls will be put in place should the economic circumstances make it necessary.
In contrast, the US Federal Reserve is set to increase interest rates over the next year, as the US economy has a much more certain outlook than the UK economy. This will have the effect of strengthening dollar, which means that it will strengthen further versus the pound.
A weaker pound is both a bad and a good thing.
It’s bad because it could cause higher inflation, as the cost of imports rises. Shopping bills may rise and eat into disposable incomes, thereby causing consumer spending to come under pressure. However, a weaker pound also means that companies that report their earnings in sterling but which operate mainly abroad gain from a positive currency impact. In other words, exporters become more competitive and their sales recorded in foreign currencies gain a boost when translated into sterling.
The FTSE 100 is full of international stocks, many of which have next to no exposure to the UK economy. In this sense the FTSE 100 is detached from the UK economy. As such, the outlook for the UK economy has less impact on the FTSE 100’s performance than on the pound, since many of the FTSE 100’s constituents are more directly impacted by the performance of the US and Chinese economies than they are by the UK economy.
This combination of a positive currency translation from a weaker pound and a lack of exposure to the UK economy means that the FTSE 100 has risen in recent months. With the outlook for the UK economy being uncertain, it would be of little surprise for there to be a continued fall in the pound and a further rise in the FTSE 100 in the future.