Could a stronger pound derail the FTSE 100's Brexit fightback?

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Brexit

Since the EU referendum, the FTSE 100 has risen by as much as 13.3%. For many investors, this has been a huge surprise. After all, the potential for a deterioration in the UK's economic prosperity was supposed to equate to share price falls - in the short term at least.

However, the FTSE 100 has been buoyed by a weaker pound since most of the FTSE 100's earnings are derived from abroad. As such, a weaker pound provides a foreign exchange translation boost.

Although, since the US election, the pound has strengthened versus the dollar and the euro by as much as 2.9% and 7.1% respectively. Could this bring to an end the FTSE 100's Brexit fightback?

Dollar strength

Although the pound has strengthened since the US election, the reality is that it is more likely to be a fluctuation than a decisive move. The medium term outlook for the pound remains challenging, which should mean that it continues to weaken in the coming months.

A key reason for this is the prospect of a rising US interest rate. The market has priced in a US interest rate rise in December and this would be likely to cause the dollar to strengthen versus the pound. Even if the Federal Reserve decides to leave interest rates at their current level this month, the election of Donald Trump as President is set to cause inflation to increase over the medium term.

In response, the market is now moving towards the view that the Federal Reserve will become increasingly hawkish. This is in order to cool the effect of policies set to be implemented by Trump, such as lower taxes and higher spending, which could stimulate inflation as well as the US economy. Higher US interest rates would be bad news for the pound over the medium term.

UK challenges

At the same time as the US looks set to experience a period of higher inflation, the UK may fail to undergo a much-hyped rapid rise in the price level.

Last month's CPI figure of 0.9% was 10 basis points lower than the previous month and shows that so far at least, retailers and other businesses are absorbing higher import prices instead of passing them onto consumers. This trend could continue over the short run.

Even if inflation in the UK rises as expected in 2017/18, the prospect of an increase in interest rates appears slim. The Bank of England seems to be more concerned about economic growth and unemployment rather than price rises. It forecasts a rise in inflation in 2017/18 to a figure of around 2.8%.

While this would be higher than in recent years, it is unlikely to be deemed excessive or worrying from most policymakers' viewpoints. Therefore, a loose monetary policy looks set to remain, which could keep the pound pegged back versus the dollar and the euro.

Brexit fears

Of course, a key reason for the pound's weakness is fear surrounding the UK economy's performance following Brexit.

On this front, there is scope for a further depreciation of sterling, since fear and uncertainty regarding Brexit are likely to rise rather than fall in 2017. After all, the government is due to invoke Article 50 of the Lisbon Treaty in the first quarter of next year which will set off a two-year negotiation period between the UK and the EU.

During this time, uncertainty is likely to be high and this could reduce investor confidence in the UK economy.

At the centre of the negotiations are likely to be the issues of free movement of labour and access to the single market. Both the UK and EU are likely to play hardball on these two topics, which could make negotiations long, drawn out and highly uncertain for the future of the UK (and European) economies.

Outlook

While the recent strengthening of the pound may be a cause of concern for the FTSE 100 in the short run, the reality is that sterling is more likely to depreciate than appreciate over the medium term.

Inflationary pressures are set to increase in the US as Donald Trump begins to implement his low tax/high spend policies, while the Bank of England looks set to accept a higher rate of inflation in return for a stimulus to employment and GDP growth.

In addition, fears surrounding Brexit are likely to intensify as negotiations with the EU commence. When the UK does go it alone outside of the EU, confidence in the outlook for the economy could deteriorate. As a result, investment in the UK economy may be hurt over the coming years.

Therefore, the FTSE 100's post-EU referendum fightback may continue to be positively impacted by weak sterling. However, the arrival of Donald Trump in the White House could still present a buying opportunity for long term investors in the coming months.

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