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Footsie vs sterling

A rise in sterling is only weakly associated with the FTSE 100 doing badly. But it is associated with UK shares under-performing US ones.
January 2, 2018

We’ve heard a lot recently about how the FTSE 100 and sterling move in opposite directions because a rise in the pound reduces the sterling value of the overseas earnings that provide most of the profits of our largest companies. Such a claim, though, shouldn’t be taken at face value. Things aren’t so simple.

First, the data. It is true that there has recently been a negative correlation between the FTSE 100 and the $/£ rate. For monthly changes since January 2016 it has been minus 0.39.

But this is a recent development. Since 2000 the correlation has been zero. This tells us that sterling and the FTSE have moved in the same direction as often as they’ve moved in opposite directions.

There’s a reason for this. It’s that changes in the sterling value of overseas earnings are not the only links between the FTSE 100 and sterling.

Another connection comes from global investors’ appetite for risk. If this increases, so too will the price of risky assets. Because sterling is a riskier currency than many others, this means that it will rise as share prices do. By the same reasoning, both will fall if risk appetite declines. Shares and sterling both fell during the financial crisis of 2008 and both rose during the recovery of 2009 for example. 

Yet another link is the state of the UK economy. Stronger growth in the UK, relative to overseas, should strengthen both sterling and share prices.

Both of these factors should cause a positive correlation between the pound and the FTSE 100 – and have in fact done so in the past. It’s possible therefore that the recent negative correlation between the two is simply because these two factors have recently been weak: there have been no great changes in risk appetite, for example. We cannot, however, rely upon this continuing.

If we take a slightly different perspective, we run into another puzzle.

 

My chart shows the correlation between changes in the $/£ rate and returns on the FTSE 100 relative to the S&P 500 in dollar terms. Each point on the line represents the correlation of monthly changes over the previous five years. This correlation has become more negative in recent years than ever before. That means a rise in sterling has been more likely to be associated with the FTSE 100 under-performing the S&P 500 in recent months than it was years ago.

What’s more, the same pattern holds for the FTSE 100 relative to FTSE small cap index: sterling strength has recently been more strongly associated with the 100 under-performing small caps than in the past.

Part of the reason for this is that more earnings come from overseas: miners, for example, make up more of the FTSE 100 than they did in the early 1990s.

But there’s something else. In theory, equity investors need not respond much to changes in sterling simply because these are largely noise. If today’s move in sterling tells us little about the future exchange rate - which matters for future overseas earnings – it should have little effect on share prices.

Why, then, has the correlation between the two increased?

It could be that investors have become more short-termist, and so pay more attention to day-to-day swings in sterling than they should. More rationally, it might be that more of them subscribe to the random walk theory – the idea that the least-worst predictor of the future exchange rate is the current rate.

Whichever explanation it is might not matter for practical purposes. What could well matter is that sterling might rise this year, simply because it might have overshot its fair value in 2016-17. If this is the case – and it is only an if – it is very possible that the FTSE 100 will underperform both the US market and smaller UK stocks this year.