Over the past few weeks, comments from policymakers at the Bank of England have reignited confidence in the pound and sent the value of sterling against the US dollar back to $1.30, a level not seen since mid-May.
Sterling has rallied on the back of the belief that the Bank of England will raise interest rates towards the end of the year. The bank cut rates following Brexit in an attempt to stimulate economic growth, but so far, growth has held up despite the uncertainty surrounding the general election and Brexit. The value of the currency could continue to appreciate if Brexit turns out to be beneficial for the UK.
This is mixed news for investors. On one hand, a strong economy is good for business and investment returns. However, on the other hand over the past year, the majority of the FTSE 100's gains have come from the stimulative effect of the weak pound. As the majority of FTSE 100 earnings come from outside the UK, earnings have grown thanks to better conversion rates.
This stimulative effect will evaporate as the value of the pound improves ,and as earnings return to historical levels it is likely the FTSE 100 will fall back as well.
To see just how much of a stimulative effect the weak pound has had on the FTSE 100, all you need to do is look at the index in dollar terms.
On a dollar basis, between 23 June 2016 and the end of March this year, the value of the index declined by around 2.5%. In sterling terms over the same period, the FTSE 100 added a little more than 15%, a divergence of 17.5%.
Given the fact that the FTSE 100 was trading at 6,138 before the result of the referendum became known, we can assume that the actual value of the index without the sterling readjustment would have been closer to 6,000 than 7,000 at the end of March. If sterling continues to appreciate in value it is more than likely that all of the FTSE 100's post-Brexit gains will evaporate, pushing the index back down below 6,500 and closer to 6,000, a decline of 18% from current levels.
The best stocks for an uncertain time
The best way to protect yourself from such a decline is to invest in the market's most defensive companies, businesses that have seen their share prices appreciate recently thanks to both improving business performance and weaker sterling.
Companies such as Unilever, which has benefitted from the pound's depreciation but has also recently embarked on a plan to improve margins, return more cash to investors and boost growth. Domestic-focused companies such as Lloyds will also provide a safe haven in stormy waters.
Lloyds' earnings have not seen any benefit from weaker sterling. The company's improving fundamentals have been almost entirely responsible for share price growth and investors are also buying into the business for its income potential.
The bottom line
So overall, as sterling strengthens the FTSE 100 may retrace some of its gains. The best way to avoid losses from this decline is to invest in the market's most fundamentally sound businesses with the best outlooks.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.