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Why the FTSE 100 is set to smash the FTSE 250

In the last year, the FTSE 100 has been outperformed by the FTSE 250. The former has gained 7%, while the latter is up 12%. This trend could, however, be coming to an end. While both indices could have investment potential for the long run, over the medium term the FTSE 100 appears to have more capital growth potential due to the possible impact of Brexit on the pound and on the UK economy.

Sterling weakness

Thus far, the talks between the UK and the EU have been somewhat challenging. Progress has been limited, and there is now discussion in the UK of the prospects for a ‘no deal’ scenario. With less than 18 months to go until the UK is scheduled to leave the EU, time is running out for a favourable deal for both sides. This could have a major impact on the pound in future.

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Already, the pound has weakened since the EU referendum. However, more weakness could be ahead as uncertainty builds around the prospect of ‘no deal’ between the UK and EU. This may cause confidence in the UK economy to decline, which could push the value of sterling even lower. Since FTSE 100 constituents are generally more internationally focused than their FTSE 250 counterparts, this may mean they benefit to a greater extent from a positive currency translation adjustment. This could push their valuations higher than those of the junior index.

UK economic performance

Uncertainty surrounding Brexit is already causing difficulties for the UK economy. Consumer confidence is at a low ebb, and in time this may cause a slowdown in the rate of economic growth. Furthermore, a weaker pound means inflation is higher. In fact, the rate of inflation is well above wage growth and this could mean shoppers delay the purchase of non-essential items and seek lower prices on consumer staples.

With the potential for a slowdown in economic activity in the UK, shares which rely on the domestic economy to a lesser extent may experience relatively strong financial performance. With the FTSE 100 being made up of a range of resources stocks, consumer goods companies, and financial services stocks that have little or no exposure to the UK, the index may not be affected to a large extent by slowing GDP growth in the UK economy. The FTSE 250, while also having a range of international stocks, has generally had more exposure to the UK economy in the past. Therefore, it could be affected to a greater degree by an economic slowdown.

Takeaway

While Brexit may prove to be a good thing for the UK economy in the long run, the reality is that it is causing significant uncertainty. This looks set to continue in the medium term, which could weaken the pound and the UK’s economic prospects. With the FTSE 100 having a greater exposure to global stocks, it could outperform the FTSE 250 in the coming months.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.