Last week was a turbulent one for the financial markets, as it tried to stay one step ahead of political developments around Brexit. From early in the week, there were headlines coming out regarding a possible new agreement, which was confirmed by the UK and the EU on Wednesday.
However, in a showdown in the House of Commons on Saturday, an intriguing amendment was voted through (322 votes to 306), which meant the Prime Minister unexpectedly pulled the vote on the new deal.
Yet when the markets closed on Friday (before the action in Westminster on Saturday), optimism was still fairly high. The pound (GBP) was up over 4% against the US Dollar that week, and UK bonds were up, yielding over 0.7%. The FTSE 100, unfortunately, was down 100 points from the Monday open. If you were left scratching your head, you were not alone.
Why the FTSE 100 index fell
Simply put, the FTSE 100 fell in large part due to the rally seen in the currency and bond markets. This is because historically when the currency rises in value, and when the bond market rallies, the stock market falls. City analysts call this a historical negative correlation. I prefer to call it an unavoidable annoyance.
Let’s look at the currency for example. Over 70% of FTSE 100 companies are net exporters, meaning the increased value of the pound is bad for business. Why?
Imagine you are the CEO of a large clothing firm that manufactures in the UK and sells in France. You receive your revenue in euros but have costs here in Britain. Therefore, you sell your euros into pounds when needed. Now, because the pound has risen in value, this makes the euro weaker. So when you sell your euros back into pounds, you get less oft them than you did previously. Not great.
In the bond markets, the expected future interest rate increased as traders smelt Brexit optimism. As most of the FTSE 100 companies have some form of debt, an increase in anticipated interest rates (or no chance of a rate cut) means the cost of financing debt will not get cheaper.
Let’s go back to our clothing firm — imagine you wanted to issue some new debt to buy a bigger factory. The move in the bond markets this week would mean you have to offer investors a higher rate of interest than previously thought, costing you more money in interest payments.
I would play this move in two ways. Firstly, I would buy domestic-driven companies that will benefit from a stronger pound. Secondly, I would buy companies with limited debt, that won’t suffer from rising rates.
Do not be put off by the fact that the index by itself is down, this is merely the sum of all the companies derived from the index. You are still able to find good value by applying the two parameters I mention above.
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.