Markets continued to tread a volatile path yesterday. Sterling in particular succumbed to the volatility and pessimism in the wider market incurring further loses versus the Dollar and notably the Euro yesterday. Despite the decline in Sterling, headline UK stock indices that typically exhibit a strong negative correlation with the Pound failed to catch a bid. Yesterday could therefore have marked the start of something foreboded by now-leadership underdog Rishi Sunak of markets losing confidence in the UK economy.
Due to the significance of the financial sector to the UK economy, there is a mechanism that will arrest the normally negative correlation between Sterling and equities. That is because the causality seemingly only flows one way. All other things equal, a weaker Pound boosts the competitiveness of UK exporting companies overseas and therefore their expected earnings pool. Similarly, it bolsters the UK denominated value of these overseas earnings by making the conversion of profits back into GBP more lucrative. So, it’s easy to see the mechanism by which equities are boosted by Sterling’s woes.
However, in an environment where the equity market is in the driving seat rather than the exchange rate then the correlation can turn positive. When equity market performance is weak in an environment of volatility and uncertainty, there can be a negative feedback loop into GBP. Equity markets in the UK exhibit a far higher correlation with the currency compared with currency areas including the Eurozone and the United States. It will be very difficult therefore for the Pound to recover whilst UK equity market performance remains so lacklustre and in focus.
August has continued to deal a savage blow to the UK Pound with inflation expectations seemingly being ramped up week by week. There is also now a ticking timebomb over the UK and European economies alike in yet another threat to gas provisions from Russia. Yesterday marked the first day of a three-day halt of the Nord Stream 1 pipeline. This has stoked concerns that Russia is looking to continue to leverage the provision of gas as a result of the sanctions imposed against it for its invasion of Ukraine. All eyes are on whether the gas will resume flowing once planned maintenance has been completed.
Discussion and Analysis by Charles Porter
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