With the UK set to leave the European Union on October 31st 2019, commentators are assessing the fair value of both stocks and the British Pound (GBP). The situation is fluid, with Harold Wilson famously being attributed to the quote that “a week is a long time in politics”. Whilst it is not my job to speculate on politics, I would definitely flag concern over the correlation between the FTSE 100 and GBP.
What is the correlation?
Historically, when GBP falls in value, companies within the FTSE 100 gain in value. For example, in the three months following the EU referendum in 2016, the FTSE 100 gained over 10%, whilst GBP fell over 12% against the US dollar.
On a company level, this correlation holds true. In the month following the EU referendum, GlaxoSmithKline rallied almost 20%, against GBP falling in value. An important note on this is that GSK generates over 90% of its revenue from outside of the UK.
With companies who generate most of their revenue from outside of the UK exhibiting a stronger correlation, this must offer a clue to the reason behind it.
Why is there a correlation?
The primary driver behind this correlation is that when GBP falls in value, companies who have large overseas earning are able to gain when they repatriate it back into the base currency.
Take Burberry for example. It has been performing well and has a large market selling to consumers in Asia, with proceeds in Chinese Yuan, Hong Kong dollars and US dollars. With GBP weaker than it was in early 2016, this in effect makes the other currencies stronger on a relative basis. When Burberry repatriates Yuan and HK Dollars back into British Pounds, they receive more Pounds now than they did a few years ago.
The consequences of exchange rate gains ultimately goes onto the bottom line for the respective business, boosting profitability and therefore a higher share price.
Whilst usually gains and losses offset each other over the year, post referendum we have seen continued and sustained weakness in GBP, meaning net exporters in the FTSE 100 have seen large exchange rate gains for at least two years.
Why should I be worried?
The British Pound has seen an extreme levels of weakness in mid-2019, with some analysts saying that it does not have much further to fall.
If the UK economy manages to survive past October 31st, then pessimism over GBP is likely to subside. Even if this is not evident in the short term, over the next one/two years, the value of the pound is likely to rally from current levels.
This should make the FTSE 100 net exporters (of which around 70% of the index are) less profitable by having to take on exchange rate losses via stronger GBP. In term, this could drag the FTSE 100 index lower.
Overall, this correlation could be an unpleasant reminder to equity investors that asset classes do not always work together positively.
Jonathan Smith has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended Burberry. 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.