The inverse correlation between the equity and currency markets has been a widely recognised trend in the financial markets, particularly revealed through capitalisation weighted blue-chip indices. The principal rationale underlying the relationship is that any large company’s success in the 21st century heavily relies on expanding beyond serving domestic markets unless it wields monopoly power, which is only true for some players in the utility sector.
Companies of greatest market capitalisation are usually multinationals that operate in and export many of their products to foreign countries, and in order for foreigners to purchase goods, they must convert their currency into the company’s home currency. Demand for a country’s currency will be higher when it is considered cheap, and lower when it is considered expensive relative to the buyer’s currency, thus affecting the relative balance of exports and imports in the economy.
The second half of 2016 saw many changes in the political and economic landscape, firstly with the unexpected Brexit outcome, and then with Trump’s election as US president. Rapid changes in fiscal and monetary policies have ensued, and many experts have argued that these ‘black swan’ events have made US and UK currencies sentiment-led so that the typical relationship between the currency and equity markets are more prone to being disrupted. But has this really been the case in the UK and the US?
UK Stocks Mirroring the Pound
- (Figure 1: FTSE 100 (Orange) and EUR/GBP (Blue))
Since the Brexit referendum, an increasingly volatile environment has been prevalent in both UK currency and equity markets.
The rapid depreciation of the pound’s value following the Leave vote was accompanied by the FTSE 100 to hit a 10-month high at the beginning of July. This was largely led by the weaker pound helping the dominant companies comprising the index starting from energy giants BP, Glencore and Shell, and consumer goods firms like Unilever and Diageo, to record overseas earnings that were worth much more when repatriated into Sterling. Fears that the UK would not be able to freely trade with EU countries had not materialised at that point, and as expected, exports saw a boost as foreign countries were encouraged to import goods from the UK due to the advantageous exchange rate.
August saw a positive correlation as the Bank of England announced that rates might be cut to boost the economy, which however did not trigger a stock rally as expected, as the 10% gain registered since the vote had already partially priced in confidence in the UK economy.
Markets remained inversely correlated from September going into October, with Theresa May announcing that Article 50 would be triggered in March 2017. As the pound fell further against the euro and dollar, the FTSE 100 climbed to a high of 7000 albeit at a lesser rate than previously, and subsequently fell during October as a low exchange rate coupled with higher-than-expected inflation figures raised worries that the Bank of England may increase interest rates which would create a more challenging environment for big companies. Furthermore, fears about trading barriers between the UK and the European bloc were realised as May announced her agenda for a ‘hard Brexit’, reducing investors’ optimism about UK Multinational earnings that was gradually priced into the stock market.
November saw a move away from the inverse relationship, with both the pound and FTSE increasing. This was partly due to the EUR/GBP rate being affected by uncertainty within the eurozone regarding the outcome of the Italian Referendum in December, and partly due to Trump’s election instigating a rally in global equity markets as UK Corporations operating in the US, especially financial companies such as Barclays and HSBC, saw their share prices jump.
December saw a relatively flat EUR/GBP pair as both currencies depreciated at a similar rate relative to the appreciating dollar. On the other hand, the FTSE commenced its rally with an increase of 1.5% on December 7th, aided by upbeat expectations regarding Rio Tinto, WPP and Unilever financial performance.
Win Some, Lose Some
However, the benefits of in exports come with the cost of expensive imports. Since the UK economy is primarily centred on services rather than manufacturing, households found it difficult to stop importing goods from abroad, particularly European food and beverages and technological products from the US. This behaviour inevitably resulted in a £2.6bn increase in the UK trade deficit in January. The announcement pushed the pound lower, and consequently the FTSE higher, bringing about a record-breaking 13 days of gains.
A quick reversal occurred in mid-January as the pound showed gains after some of the uncertainty regarding hard Brexit priced in was lifted following May’s speech and an inflation rate of 1.6% showed positive signs for domestic growth. The FTSE’s value, previously led by expectations of inflationary growth in the UK, fell significantly as the pound appreciation offset the upbeat growth figures. Furthermore, British American Tobacco plunging shares were also a factor as its acquisition of Reynolds American was announced.
The FTSE vs. the Pound
By the end of January, the FTSE registered gains as the pound appreciated against the euro, primarily because UK retail companies do not feature heavily in the index. February led to a new FTSE rally as mining share prices increased. The mid-cap FTSE 250 rallied too, hitting successive records in mid-February, suggesting that the pound was not the primary driving force of UK equities’ bullish performance.
Indeed, February saw some volatility in the pound’s value not only against the euro, but also against the Swiss franc and the dollar that looked very different from the FTSE’s ascent. Rising commodity prices that increase mining companies’ earnings, as well as a weakening pound going into March due to disappointing retail sales figures and fears that Scotland may call an independence referendum helped the index.
As the UK nears the triggering of article 50, political uncertainty has imposed a ceiling on the value of the pound. The FTSE has increased to a greater extent than the currency, hitting ever-increasing highs recently, but will likely be volatile in March as uncertainty regarding a rate hike and EU exit negotiations will see investors taking on diverse views.
Bullish Sentiment Since the US Election
While the pound and the FTSE have behaved as expected, the effect of Trump’s election in early November on currency and equity markets drastically altered relative price movements.
In many ways, political changes in the US have been more pronounced than in the UK, as markets have moved freely in accordance with the president’s and the Fed’s agenda. On the other hand, the S&P 500 index includes not only a greater number but also a wider range of stocks than the FTSE 100, meaning the inverse correlation expected with respect to the dollar should be looser.
The Trump Effect
In the period leading up to November, despite divergences during July, overall the S&P and the dollar-yen pair moved against each other given a relatively stable political climate under Obama.
As Trump was elected in early November, the dollar and the S&P dipped dramatically for a day before recovering and sustaining a rally over a large part of the month, spurred by the president’s intention to enact aggressive expansionary fiscal measures geared towards lowering corporate taxes, increasing government spending on infrastructure, and deregulating the financial sector.
The increasing dollar valuation may have put pressure on manufacturing companies that greatly rely on exporting overseas, but the bullish outlook of investors on the economy as a whole was priced into the most popular US index, offsetting downward pressure exerted by expectations of lower repatriated earnings for some multinationals.
Enter the Fed
The anticipated rate hike, which would be only the second in a decade, also contributed to confirming the healthy state of the US economy and the high probability of inflation targets being met. Since rates are still very low for historical standards, typically they should not adversely affect the majority of blue-chip companies included in the S&P.
When the 25 basis point rate hike was confirmed in mid-December, both the dollar and the S&P 500 index remained largely flat until the beginning of 2017. Strong US economic data benefitted the outlook on the economy, while the rate hike caused a surge in bank stocks which benefit from increased borrowing rates.
The risk of an overvalued US equity market has not stopped indices from climbing even more since the beginning of 2017. On the other hand, the dollar has weakened slightly since Trump stated he believed the currency to be overvalued in mid-January. Since November, the Federal Reserve has acted as a countering force to Trump, with an imminent rate hike being a realistic possibility in March. During February, the S&P has continued to climb at an ever-increasing rate as the dollar has weakened, perhaps signalling that, with the political shock subsiding, the expected inverse correlation between currency and equity markets is making a return in the US.
UK and US markets have reacted very differently to the changing political and economic landscape, resulting in differing relationships between their respective currency and stock markets. While the UK’s FTSE 100 has indeed been for the most part inversely correlated to the pound, markets seem to be distancing themselves from the trend as Article 50 is triggered.
On the other hand, US is entering a more stable phase in which the expected relationship between the dollar and the stock market is being re-established, as investors’ excitement surrounding the US economy under Trump has subsided at least until the promised tax cuts and spending programme are realised.