How A Weaker Pound Could Absorb Market Shocks

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Includes: ADRU, DBEU, DBEZ, DBUK, DEZU, DRR, DXPS, EEA, EPV, ERO, EUFX, EUO, EURL, EWU, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEE, FIEU, FKU, FXB, FXE, GBB, GSEU, HEDJ, HEWU, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, PTEU, QGBR, RFEU, SBEU, ULE, UPV, URR, VGK
by: BlackRock

Markets remain nervous after Brexit, which sent the British pound plummeting. Yet, Isabelle points out some of the long-term benefits for the United Kingdom from a weakening currency that many investors are forgetting.

A number of different headlines have dominated the news around the Brexit decision: U.S. and European stock markets sank. Uncertainty continues to sweep the globe. The value of the pound plummeted to its lowest levels in 30 years.

A good thing for the long run

Although the precipitous drop in the pound sounds bad, it might actually help the British economy over the long term by acting as a shock absorber to help the economy rebound. We've already started to see this effect in the FTSE 100, the index with the 100 largest companies listed on the London Stock Exchange, which has rebounded strongly since the news.

The opposite effect has taken place throughout the rest of Europe: The euro has avoided serious currency fluctuations, yet stock markets have taken a major hit.

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This relationship between currency values and stock market indexes works in a few ways. Currency can serve as a shock absorber by lowering the relative price of U.K. products around the globe: As the pound weakens, British products look cheaper to consumers buying items using other currencies. U.K. firms are already dominant in a number of global industries like machinery, pharmaceuticals and precious stones, so firms in the rest of the world in these sectors will have to cut prices or work harder to acquire business, since British prices will become more affordable for international consumers.

The other way currency can absorb economic shock is that all earnings coming from abroad become worth more when converted into pounds. For example, if $100 USD was previously worth £60, a weaker British currency might mean that $100 is now worth £80. To wit, a weak pound is a boon to British companies operating globally. In that context, the spike in the FTSE 100 is logical, since about 75% of the earnings of the companies included in that index come from abroad. That said, from the point of view of unhedged U.S. investors, FTSE 100 holdings still lost a lot of their value, reflecting the currency depreciation.

Will the pound stay weak?

We expect the currency to depreciate further from here given the United Kingdom's large current account deficit (7% of GDP). If it is not matched by equally large capital inflows (which is unlikely given the highly uncertain circumstances), the pound has to weaken to balance supply and demand in the foreign exchange market.

When weak currency isn't an option, something has to give

By contrast, the euro has remained much more stable. Chiefly, that's because the strong economies in Europe compensate for fluctuations in more volatile ones within the currency union. Prior to adopting the euro, European countries often suffered currency crises; under the euro, that no longer happens. For many, that's a good thing.

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There's a downside, though: When a big economic shock like Brexit occurs, some economic indicator has to move in order to reflect the increased volatility and uncertainty. If, as in the case of the EU, the currency can't absorb the shock, something else needs to. As a result, the British stock market is already back on an upswing, while the rest of Europe - already mulling what it will mean to lose one of its most influential constituents - may be picking up the pieces of its equity markets for some time to come.

This post originally appeared on the BlackRock Blog