The unpredictable relationship between currency values and stock markets – August Key Indicator

Too often the assumption is made that when a country’s currency value drops its stock markets will rise as its exports become more competitive.

The current economic situation in the UK and elsewhere is an illustration of why this may be an over-simplistic assumption.

Last week ended with £Sterling at its lowest value against the US dollar for two years at $1.2162 and against the Euro at €1.0948 while at the same time the FTSE100 closed down minus 2.34% at 7407.06.

This suggests that the previous so-called assumptions are no longer valid.

In commenting on this it should be noted that the European, US, Japanese and Hong Kong stock markets also plunged.

What is causing currency values and stock market  turbulence?

The signs that both the global and UK economies are volatile and have been for some time. Evidence for this can be deduced from the monetary stimulus by Central Banks.

In May the OECD (Organisation for Economic Co-operation and Development) revised its growth forecast for the UK to 1.2% this year and 1% next year in the light of ongoing uncertainty about the future of the economy.

In June the WTO (World Trade Organisation warned that 20 new trade barriers imposed by G20 economies between mid-October and mid-May, threaten to increase uncertainty, lower investment and weaken trade growth.

By July, Moody’s, the credit rating agency, and Mark Carney, BoE (Bank of England) Governor were both warning that a new cold war in trade would have a deep effect on the world economy.

Moody’s was also predicting a recession in the UK if it crashed out of the EU without a deal in October. It followed up later in the month that this was now more likely following the outcome of the Conservative leadership contest, which resulted in a new Prime Minister, Boris Johnson.

So, what actually influences currency values? The BBC has a helpful guide to the factors that can play a part:

* Economy: Strong economies have strong currencies because other countries want to invest there;

* Savings: When UK banks raise interest rates, holding savings or investments in pounds becomes more attractive;

* Prices: If UK goods are cheaper than those abroad, they will be attractive to foreign customers who buy Sterling to purchase them. This in turn increases the exchange rate;

* Public finances: The state of a government’s bank balance, or how much debt it has, can also affect the exchange rate;

* Speculation: The exchange rate is highly vulnerable to currency speculators, who buy and sell Sterling or who bet on currency movements based on their view of future events.

And how does currency value influence stock markets? A 2017 article in City AM argued that the strength of a country’s currency can have a surprisingly large bearing.

It argued that after President Trump was elected in the US, the S&P 500, the benchmark US share index, rose 10% to new all-time highs in the month following and cited the US dollar, which gained 3% during the same period as a key driver.

By comparison, after the 2016 Brexit referendum in the UK Sterling tumbled while the FTSE 100 rose sharply. In the three months following Brexit, the index rose 10.4%, largely, it argued, because the majority of FTSE 100 companies receive their revenues in foreign currency.

So what is different now to have caused both Sterling and the FTSE 100 to drop simultaneously? Arguably against a backdrop of slowing global trade and Brexit uncertainty a significant impact has been the ongoing trade war between the US and China.

The latest move has been a decision by Donald Trump to impose new tariffs on a further $300bn of Chinese imports in addition to those already in place.

Clearly, in such a volatile situation all the old “assumptions” about currency values and market behaviour are called into question and businesses and investors may need to review the basis on which they make decisions!

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