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There’s a reason why the FTSE 100 falls when the pound rises – and vice versa

By Tim Worstall

11:00, 28 November 2022

FTSE 100
Earnings from many companies in the Footsie are in foreign currencies - Image: Shutterstock

One of the stylised facts – stylised here meaning just ‘something that happens’ – about the London markets is that the FTSE 100 index falls when the pound rises on the foreign exchanges.

Equally, the opposite happens: when the GBP/USD rate falls, the Footsie rises.

To a certain extent this also happens with the GBP/EUR rate. Again, this also happens to a lesser extent with the FTSE 250. As with anything that happens with some regularity in financial markets there's a reason for this too.

FTSE 100 (UK100) price chart

But before we all go off to place our positions on this thing which happens like clockwork, we need to understand why it happens. Only then, once we know why, can we work out whether it's worth the when.

For the danger of all of these things that happen like clockwork is that they can be overwhelmed by other things that are happening out in that chaos that is a modern economy. That is, given that we live in a world of many influences this specific one might well be true, run on rails even, but that doesn't mean that positions based upon it are always going to work.

Too many other things out there happening as well, see?

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The Brexit influence

There was a time when this was the dominant influence upon the stock market too. Back when we were all voting on Brexit, then worrying about what kind it would be. The more the divorce seemed to be proper and permanent the lower sterling got.

This is simple trade economics – when the terms of trade change so does the currency value. The greater the trade barriers are going to be the less trade there will be – so, the currency falls in value.

And each day that it looked like hard Brexit was going to win, the lower the pound got and the higher the FTSE indices climbed. When it looked like supporters of a soft Brexit were going to succeed then the pound rose and the stock market fell.

Pound vs dollar (GBP/USD) exchange rate chart

FTSE 100 – an international benchmark

The reason is really very simple. The FTSE 100 index is not the list of largest companies in the British economy. It's also not a listing of the British economy.

It's a list of the largest companies listed in London. Some of which are almost entirely operating in the UK economy, such as, Admiral (ADMI); some of which have near no operations in the UK – say Anglo American (AALI); and one of which doesn't even do its accounting in sterling – Unilever (ULVR).

So, some portion of the revenues – thus profits – of the companies in the FTSE 100 are made outside the UK, in non-GBP currencies. They're not reliant upon the status of the British economy in the slightest that is. Except in one final manner. Which is that those profits are translated into pounds (except for Unilever) when they are reported.

GBP/USD

1.30 Price
+0.450% 1D Chg, %
Long position overnight fee -0.0046%
Short position overnight fee -0.0036%
Overnight fee time 21:00 (UTC)
Spread 0.00013

USD/JPY

156.48 Price
-1.130% 1D Chg, %
Long position overnight fee 0.0111%
Short position overnight fee -0.0193%
Overnight fee time 21:00 (UTC)
Spread 0.010

EUR/USD

1.09 Price
+0.400% 1D Chg, %
Long position overnight fee -0.0087%
Short position overnight fee 0.0005%
Overnight fee time 21:00 (UTC)
Spread 0.00006

AUD/USD

0.67 Price
+0.080% 1D Chg, %
Long position overnight fee -0.0066%
Short position overnight fee -0.0016%
Overnight fee time 21:00 (UTC)
Spread 0.00006

So, if the pound falls all those foreign revenues and profits are worth more in pounds. A stock market index – FTSE 100 – which measures the value of companies trading in foreign in pounds rises when the value of the pound falls.

How much this is true will depend upon how much of that FTSE 100 revenue – and profit – comes from outside the UK and outside sterling. The answer for that main index is, around and about, 75%. Only 25% of the revenues and profits of those 100 top companies listed in London actually derive from the British economy at all.

FTSE 250 – a measure of the UK economy

Things become a little different once we move down a notch to the FSTE 250. Again, this isn't a list of British companies, it's a list of companies listed in Britain, ranked by market capitalisation. Here about 50% of revenues and thus profits come from within Britain and the sterling area, about 50% from outside. So, the influence of the sterling exchange rate alone is less here. The influence of purely domestic British economic conditions is higher. 

One slight difficulty with this as a trading opportunity is that it's not, specifically at least, the GBP/EUR, or GBP/USD, rate which connects with the FTSE 100 or FTSE 250. It's something akin to the blended trade weighted exchange rate which does. Note the “akin” there, it's not the same thing. But the trade weighted rate looks at the exchange rate compared to the volume of trade across different currency pairs.

Our equivalent here is the rate across the different currencies in which British listed companies are earning their profits. The dollar and euro are the vast majority of it, of course, but it's still not the same as the trade weighted rate.

Caveat emptor

It's possible to play that difference. People in fact did back in the 2016 to 2018 period of gross uncertainty. Have this position in the FTSE100 here, that in the FTSE250 there, that third in the GBP/USD rate (which is a good proxy, even if not perfect, for that trade or revenue weighted FX rate) and it's the change in the three relative prices which makes the profits.

The difficulty for us now is that this is not the one, sole, or dominant, influence upon prices. The FX rate still matters for the indices, sure it does. But now so do interest rates, the risks of recession and so on.

Which brings us to another similar trade and thought. It will not be true that the FTSE 100 will track the performance of the British economy. Say it does worse than other European ones, or the global one. OK, so that happens – but 75% of the FTSE 100 is that global economy, not the domestic one. The FTSE 250 will have more of the domestic influence but even there it's still only 50%.

The really useful part of this little stylised fact is not so much in suggesting trades right now. It's in noting something about trades we might set up right now.

We might think that the British economy is about to get whacked. We might be right about that too. But the British economy getting whacked does not mean the FTSE 100 sinking like a stone. Because too much of it isn't associated with the British economy at all.

The FTSE 250 is more linked.  So, a tanking UK economy will lead to a divergence in the performance of the FTSE100 against the FTSE 250. But we shouldn't go assuming that a UK only recession will drop the FTSE100 – things are more complex than that.

Markets in this article

ADMl
Admiral Group
26.04 USD
0.09 +0.350%
AALl
Anglo American
23.100 USD
-0.045 -0.190%
EUR/GBP
EUR/GBP
0.83965 USD
-0.00042 -0.050%
UK100
UK 100
8172.2 USD
-23.2 -0.280%
GBP/USD
GBP/USD
1.30324 USD
0.00588 +0.450%

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