Amidst all the volatility we’ve seen in the FTSE 100 and wider stock market over the past month or so, the pound (GBP) has also been moving around. As investors, it’s important to look at different asset classes as they’re all linked together. GBP/USD and GBP/EUR are two currency pairs that have the largest impact on the FTSE 100.
GBP/USD has been low for a while, but last month it hit the lowest level since 1985. This was when it traded down below 1.15. While it has recovered partially, a lot of banks are expecting it to move higher over the next year. This could be bad for the FTSE 100 index and the firms within it.
What’s the issue with GBP?
The potential risk of a higher GBP/USD rate is that it makes exports more expensive. Imagine you’re a large toy manufacturer based in the UK with a 10% profit margin. You make the toys in London, paying staff and factories in GBP. Then you export all around the world and sell in USD. When GBP/USD is at current levels (1.25) this isn’t a problem for you. But what if the exchange rate moves to 1.3750? Well then the stronger GBP means your profit margin is wiped out.
This is because the cost of exporting has gone up, thanks to the stronger GBP against the USD. Given around 70% of FTSE 100 firms export more than import, the above situation is a relevant illustration. If we do see GBP/USD move higher, this could mean a hit to the earnings and profit margins of firms within the index.
Don’t panic, think smart
As a stock investor, I can protect myself against the potential exchange rate rally. I could try to steer clear of heavy exporters within the FTSE 100 index. One good example I wrote of recently is Ocado. The business is thriving at the moment. It’s mostly a domestic business. It does have some exposure to the US via a partnership, but this is small. This limits the exchange rate risk the firm has, especially on a move higher in GBP/USD.
I can try and protect myself against a stronger GBP by being smart with which exporter I invest in. GBP/EUR is expected to remain a lot more stable than other currency rates. Therefore, picking an exporter that sells into Europe may be better than one that sells elsewhere. An example of this is Mondi. The firm has offices in almost all countries within Europe, despite being listed in London. Thus the firm is unlikely to suffer as much from a move higher in GBP/EUR than some firms that trade more on GBP/USD.
One further way is to look for firms that are truly global in nature, which can allow them to trade in multiple currencies. This gives a firm more limited exposure to GBP/USD fluctuations or to any one currency pair specifically. A firm such as HSBC would be one example of this.
Ultimately, it’s important to take into account the impact a currency can have on the FTSE 100. But don’t obsess over exchange rates. Our Foolish investing philosophy is all about identifying quality businesses with hard-to-replicate offers, strong balance sheets and excellent cash generation. They should prosper whether the pound is up or down.
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Jonathan Smith does not have shares in any firm mentioned. The Motley Fool UK has recommended HSBC Holdings. 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.