If you’re invested in the FTSE, I’ve got some great news.
Like me, you’re probably reading all about a tumbling pound in the press.
If you believe the papers, there’s a simple reason for it. The markets are finally entertaining the notion of Scottish independence. All that uncertainty’s sent the pound reeling, they say.
But I’m going to show you that there’s much more to this story than that.
The markets know something. And if you do have money in the FTSE, I reckon you’ll want to know it too.
A cold hard truth about the British economy
Let’s start with a bit of background.
For years there’s been a collective hope in Britain that our economy has been normalising, that it could therefore weather rate rises.
So, until recently, it was kind of assumed that our relatively strong economy would lead to early interest rate hikes.
But Mark Carney’s team at the Bank of England has changed the rules of engagement. “No way”, they say.
Looks like the economy isn’t so strong after all.
And now, the fact that there won’t be any meaningful interest for years to come idea is finally getting through to holders of sterling. “If you want a return on it, then take your money elsewhere!”
This is a cold hard realisation that Britain’s post-crisis boom is fake. That it’s based on debt – your average Brit’s propensity to increase it, and the Bank of England’s propensity to allow it.
The markets are starting to see through the Bank of England’s rhetoric, and that’s what’s taking its toll on the pound.
So why’s that good news for the FTSE?
At long last – Britain can become competitive
Well, this could be just the prod the market needs to break new highs.
Why? Consider this: during the first six months of the year, 137 UK companies came out with profit warnings, citing the strong pound as damaging for exports.
Say a European car manufacturer wants to buy nuts and bolts from a Birmingham supplier, then a 15% rise in sterling has effectively put a 15% surcharge on the product.
In reality, the exporter will probably drop his price a bit. After all, his production costs may have fallen as any raw materials from Europe got 15% cheaper. But you see the point. And it’s a very real concern for many UK small-cap companies, especially ones that haven’t hedged their currency positions.
As such, a weakening pound will be a great boon as it brings back competitiveness.
It’s not just small caps like our Birmingham supplier that will benefit, either…
For the large caps, things are even better
Large cap companies will benefit too, although things are a little more complex when we come to them.
Just as with their smaller cousins, sales of UK manufactured products become more competitive with a falling pound. But of course, few large caps actually make that much stuff on UK soil anymore.
At one extreme, an oil producer, or miner – of which the FTSE has plenty – isn’t doing very much in the UK at all. Maybe just a head office.
Most of its costs, and most sales for that matter, are a foreign currency affair. These multinationals also own foreign subsidiaries, all of which deal and make money abroad.
So when the company comes to reporting results, it’s a matter of translating the figures back to sterling. And for the vast majority, the strong pound has led to misery.
Last week Diageo was the latest to spell out the effects. Management was keen to say, “It’s not our fault, Guv… profits were off £350m simply because of the strong pound”. For British American Tobacco, it was nearer £400m.
This how the translation loss works.
Let’s say your foreign subsidiary makes $100m profit in the USA. When the pound is strong, and you get say $1.8 for it, the translation to sterling generates a £55m profit.
But when the pound is weak – say you’re now only getting $1.4 – suddenly profits translate to £71m. That’s quite a difference!
Will stocks hit a new high?
I have no doubt that there’ll be a collective cheer going round British board rooms as the pound continues to weaken.
Not that I’m trying to say that an economy built on sand is good, you understand. And I’m certainly not saying there aren’t drawbacks to a weak pound.
But for many of our quoted companies, this could be just the catalyst they’re looking for to spur them to new highs.
And that’s great news for investors.