The pound has been on a steep downward trajectory over the past several days. Jitters have sent the value of our currency to levels not seen since 1985. I have had several friends tell me that they’re worried about the potential effect of a weak pound on their FTSE 100 portfolios.
Therefore today I want to discuss how the choppiness in the exchange rate may affect economic life in UK as well as the value of British companies in your portfolio.
How the pound has fared
Financial markets hate uncertainty. And the health and economic developments surrounding the novel coronavirus are less than certain at this point. In addition to a global equity market crash, the Covid-19 outbreak has also caused considerable volatility in exchange rate markets.
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As I write, the pound-to-US dollar rate has been leading the sterling rout. On 18 March, it plunged about 5% and fell beneath 1.15. And plenty of City analysts expect it to tumble even further.
The weak pound is also a result of an increased global demand for the greenback. Most investors are well aware of how panic has set in across equity markets worldwide. And the uncertainty is clearly benefiting US bonds and the dollar at the expense of most other currencies and asset classes.
The pound had actually been suffering for about four years. Following the Brexit referendum result in June 2016, its dramatic fall started. The value of sterling relative to the US dollar fell from about $1.47 to $1.22 in just five months after the referendum.
After the referendum, it 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. As of 21 March, it is hovering around 1.08.
Then as the no-deal Brexit fears began to recede in late 2019, sterling started showing strength and remained better supported. But the recent viral outbreak has changed the dynamics in the currency market.
A weak pound may not be all bad
In simple terms, a devaluation of the pound would make British goods cheaper to buy, potentially boosting the amount of UK exports overall.
That said, a weaker pound makes imported raw materials more expensive. And the increased costs eventually get passed down to the consumer.
But most of the companies in the FTSE 100 are multinational conglomerates and up to three-quarters of their revenue comes from overseas.
Therefore, when the pound falls, especially significantly, their sterling-denominated earnings rise considerably. The dollars and euros they are earning outside the UK become worth more pounds, leading to an increase in profitability.
The effects of exchange rate movements tend to be less clear-cut for the companies in the FTSE 250 index as they usually have a more domestic focus. So they’re more directly affected by the short-term developments in the economy and consumer sentiment.
Foolish Takeaway
There are many reasons for exchange rates to move on a daily basis. And it’s anyone’s guess as to how the currently weak pound may react to various national or global developments in the rest of the year.
So what can the average investor do as currencies gyrate? I’d keep calm and keep investing regularly in good companies. If you’re unsure about selecting individual companies due to increased uncertainty an industry may face, then you could buy into a FTSE 100 tracker fund.
