As we all wait to find out what may be next in the Brexit saga, I’d like to discuss how gyrations in the pound against other currencies could especially affect the value of British companies in your portfolio.
The pound has suffered since 2016
Financial markets despise uncertainty and the developments surrounding Brexit have been less than certain. And it’s caused considerable volatility in exchange rate markets.
Following the referendum result in June 2016, the pound’s dramatic fall started. For example, the value of sterling relative to the US dollar fell from about $1.47 to $1.22 just five months after the referendum.
The pound also fell sharply against other currencies, especially the euro. On 22 June 2016, the pound was about 1.30 to the euro. In November 2016, it was about 1.16.
Now the pound finds support
In the early weeks of the Brexit result, traders’ jitters sent the value of the pound to levels not seen since mid-1980s. And now over the past few weeks, sterling has rallied to a recent high as no-deal Brexit fears have begun to recede.
Today, the pound remains better supported, with markets showing increased confidence that there may soon be a resolution to the whole Brexit saga.
This improved sentiment is reflected in the value of the pound. Against the US dollar, it’s just shy of $1.30 and against the euro, it trades around 1.16.
The pound and the FTSE 100
Most of the FTSE 100 companies are multinational conglomerates and up to three-quarters of their revenue comes from overseas.
Therefore a weak pound isn’t necessarily bad for sales. In simple terms, a devaluation of the pound would make British goods cheaper to buy, potentially boosting the amount of UK exports overall.
When the pound falls, especially significantly, their sterling-denominated earnings rise considerably. The dollars and euros they’re earning outside the UK become worth more pounds, leading to an increase in profitability.
That said, a weaker pound also makes imported raw materials more expensive. And the increased costs eventually get passed down to the consumer. And the reverse relationship holds when the pound goes up.
Yet it’s hard to pinpoint if the “export effect” or “increase in costs” dominates, and whether investors respond equally to all firms in the FTSE 100.
Relative effects of exchange rate movements also tend to be less clear-cut for the companies in the FTSE 250 index as they usually have a more domestic focus. They’re more directly affected by shorter-term developments in the economy and consumer sentiment.
Therefore, FTSE 250 shares are likely to benefit when we have more clarity as to how our relationship with the EU will look like in 2020 and beyond.
The Foolish bottom line
There are many reasons for exchange rates to move on a daily basis. But, over long periods, they tend to respond to macroeconomic fundamentals.
The task of unwinding the deep trade, political, and social links established with the EU in almost half a century will likely have long-lasting effects on the UK economy and the pound.
However, it’s anyone’s guess as to how the pound may react to the political developments in the rest of the year. So what can the average investor do as the pound gyrates? I’d keep calm and keep investing regularly in good companies.