By: Tim Bennett
16.06.2017
16.06.2017
Our currency and our highest profile stock market index tend to move in opposite directions, Tim Bennett explains why.
In the chart below, you will see that as the red line – sterling – falls (in this case against the US dollar) our high profile FTSE 100 stock market index rises and vice versa. Whilst this relationship isn’t always 100% observable it is solid enough to need some explaining. In short, why does the stock market rise when currency traders are marking down our currency and by implication, the overall outlook? The answer lies in these two words: overseas earnings.
Overseas earnings
Many of the FTSE 100’s constituent firms earn significant amounts of their earnings overseas, particularly in the US or somewhere that uses the US dollar as a trading or reference currency. What this means is that as our currency weakens, the dollar strengthens and the value of those overseas earnings rises when converted back into sterling. That in turn boosts share prices and by extension the FTSE 100 index as a whole.
You can see this on the right hand side of the below image;
Reasons to be careful
As an investor what this fact reveals is that you need to treat the FTSE 100 index, as a UK barometer, with care;
- These days it doesn’t represent the UK economy is the same way as say the FTSE mid-250 or the wider FTSE All-Share – it also represents the many overseas operations run by its constituent firms
- The reverse relationship is also true – should sterling start to strengthen, perhaps on the back of expectations that interest rates might rise here to ward off inflation, then the FTSE 100 will suffer – and perhaps more than a purely domestic index
- The relationship between the index and the currency is complicated by the fact that a fall in sterling pushes up import costs for UK firms, so although the overall index may rise certain firms within it will suffer. Also, although the FTSE 100 may rise when the currency falls, a drop in sterling suggests that the overall outlook is deteriorating, something to which share prices cannot usually stay immune forever
Overall then, it is important to know what you are getting when you choose to either follow a particular index, such as the FTSE 100, or use it as a benchmark for a portfolio. Also be aware that whilst the FTSE 100 will give you international exposure, other indices will give you much less, or none. If you are invested overseas, directly or indirectly, you need to be aware of the impact of currency movements and ensure that you know how to manage them. Lastly, although the FTSE 100 may rise as sterling falls and vice versa, it would be unwise to use it as a 100% reliable guide to what is happening in the underlying economy.
