Why the falling pound is good news for the FTSE 100

The British pound has been one of the weakest currencies so far in 2013, hitting a two-and-a-half year low against the dollar and a 16-month low against the euro.

The reasons for the fall have been five-fold, explained Justin Urquhart Stewart, director at Seven Investment Management.

He cited sluggish domestic growth in the UK; current policies; external investors' loss of confidence in the UK; a strengthening dollar pushed by growth in the United States; and the easing of eurozone sovereign debt tensions.

Investors "have realised that Britain is actually in its lost decade," said Urquhart Stewart.

Currency markets have become more and more frantic over the past weeks; particularly after the Bank of England (BoE) Monetary Policy Committee's eight-to-one vote in favour of another round of quantitative easing (QE).

This monetary stimulus means the BoE is choosing to print more money to buy bonds, and as pound supply increases, sterling's exchange value could erode further.

Not all analysts supported the move: in an interview with Bloomberg, HSBC's global head of currency strategy David Bloom argued the UK was in a "currency war", while the BoE's growth plans through the weakening of the pound were "failing".

Mike van Dulken, head of research at Accendo Markets, added the currency wars were leading the way for a "competitive devaluation" in which the pound was taking part.

Downgrade for the UK

The pound fell to a multi-year low against the dollar at $1.51, and a multi-month low against the euro at €1.13 on Monday after Fitch stripped the UK of its top AAA credit rating on Friday.

But sterling, which had been trading at $1.62 on 1 January 2013, had already fallen to $1.52 by 22 February, before the downgrade was actually announced.

Seven Investment Management's Urquhart Stewart said the downgrade itself had made little difference "because most of us who have been watching it were expecting it. So, it was almost better to get it out of the way."

But Howard Archer, chief UK and European economist at IHS Global Insight, said the downgrade had and will have an effect on sterling.

"The pound looks to be the most vulnerable from the UK's loss of its AAA rating, particularly as it has already taken quite a hammering recently from a combination of factors," he stated.

Happy days for investors

Yet analysts agreed stockmarket investors could expect merrier days.

Indeed, best-performing equity markets were associated with the weakest currencies in 2012, said Norman Villamin, chief investment officer for Europe and Asia at Coutts.

"When currencies fall, markets often rise," he stated.

In the case of the Japanese yen, the currency weakened by 9% year-to-date and over 36% since the last quarter of 2012 - but equities returned an impressive 13.5% gain over the period. In Europe, Swiss equities rose nearly 9% when the Swiss franc weakened against both the euro and the dollar.

Back to Britain, and the statistics follow the same trajectory. While the pound has fallen by 6% so far this year, UK equities have risen almost 8%, "outpacing much of Europe", confirmed Villamin.

Yet significant currency movements can impact total returns, both positively and negatively, when trading is not made in the local currency.

In 2012, a sterling-referenced investor with a US-based portfolio (S&P 500) would have seen its performance of 6% more than double to 13.1%. But a Hong Kong dollar-referenced investor would have seen the performance of a UK portfolio (FTSE 100) of 7% depreciate to just 0.3% over the period.

Exporters' luck?

Theoretically, a weakening pound means British exporters' products have become more competitive and attractive to foreign markets, supporting the UK government's target of doubling exports to £1 trillion by 2020.

"A further retreat in the pound may actually be no bad thing for the UK economy - as long as it is limited and orderly," commented IHS's Archer.

"It would help UK competitiveness at a time when global growth is hopefully set to pick up gradually."

However, Glenn Uniacke, head of options at foreign-exchange specialist Moneycorp, argued "the UK's comparatively small export market is unlikely to get a major boost from weak sterling.

"Instead, the economy will suffer from higher inflation caused by the proportionately higher cost of the products we import."

Indeed, in a press conference supporting its latest inflation report, BoE governor Mervyn King warned: "Inflation is likely to rise further in the near term and may remain above the 2% target for the next two years, reflecting sterling's recent depreciation and the persistent contribution from administered and regulated prices."

What lies in store for sterling

Meanwhile James Butterfill, equity strategist at Coutts, said: "We continue to see a weaker euro as part of the solution for recession in France, Italy and Spain, for instance."

"Euro strength versus sterling would not make sense to us," he added, especially as sterling has plummeted 8% against the euro since the beginning of the year.

In the current environment, will the pound trade at parity with the euro?

"I wouldn't be at all surprised if in due course we find the pound being pulled towards parity with the euro," argued Urquhart Stewart.

"But not immediately'" he added, "because you have to look upon the euro as a huge ship in terms of scale, size of the currency, whereas sterling is a relatively small trailer next to it and so, as the ship moves, so it pulls the trailer with it, and so we are increasingly influenced by what happens in the euro."

Urquhart Stewart explained despite economic flattening in the eurozone, the euro would remain strong due to the sheer scale of the trading block, primarily because of the German economy.

"If anywhere was to grow significantly it would probably be the eurozone [economy], rather than our own," he concluded.

Looking ahead, further dips are forecast, with Coutts' Villamin estimating stockholders could see the sterling index reach $1.48 by year-end, while HSBC's Bloom estimates the pound to reach a healthier $1.578 by end-2013.

Coutts' Jackson explained, "The lack of plausible domestic sources of support for UK growth makes it more likely that sterling will keep falling. Continued deleveraging by consumers suggests spending is likely remain weak over 2013."

Nigel Green, deVere group chief executive, agreed: "With the government and the Bank of England seemingly more than content with a lower pound at the moment, and with Moody's downgrade of the UK last week, it is likely that sterling will remain reasonably low for some time."

Time to reallocate?

Investors should take a medium-term view on this, and make sure their assets are suitably spread and not put in UK companies that have no or too little foreign exposure.

Urquhart Stewart said British investors had to look at the "good news", as over 60% of FTSE 100 companies' income is derived from overseas.

"So, therefore they will benefit because their overseas earnings will effectively now be worth more," he explained.

Indeed, companies with a domestic focus have suffered from sterling's drop, particularly those most exposed to UK consumers, as rising costs of essentials like petrol squeeze disposable incomes.

Coutts' Butterfill suggested investors could look at Asia and emerging markets in general, as over 27% of the FTSE 100 (UKX) companies' revenue comes from growth markets.

But this drops to 13% for the FTSE 250 index of mid-cap companies, which has a whopping 55% exposure to the UK. "We therefore prefer large-cap companies with high foreign-revenue exposure," concluded Butterfill.