Looking for a hedge against inflation? The FTSE 100 might be a good bet

When the UK voted to leave the European Union on 23 June 2016, the equity market was thrown into disarray as confused investors – many of them global, and hence rather too far away from the political action to make much sense of it – sold first and asked questions later.

However, despite that –and despite the general sense that the UK blue-chip index has been a terrible investment – over the next three and a half years, the FTSE 100 didn’t do all that badly.

It returned around 5% a year, excluding dividends (which would have added another 3% to 4% a year onto the total) before the coronavirus pandemic upended the global economy.

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That’s nothing to write home about compared to US stocks, but it was a positive real return (ie, after inflation). And the same factors that kept the FTSE 100 above water during those turbulent years, could do the same now.

The FTSE 100 is a global index with a sterling hedge

Companies in the FTSE 100 derive roughly 75% of their revenues from overseas. As a result, when the pound plunged after the Brexit vote, the value of these earnings rose. What’s more, the international footprint of the index offered diversification away from the uncertainty facing the UK economy after Brexit.

These factors are still working in the index’s favour today. A weak pound will boost company earnings and international diversification will help as the UK runs headlong towards stagflation.

The make-up of the index also suggests that it could act as an inflation hedge. Energy and basic materials stocks make up around 20% of the index, with utilities and healthcare making up another 15%.

Rising commodity prices should help producers to act as a hedge against inflation, while healthcare companies tend to have pricing power, enabling them to hike prices in the face of rising costs. Utilities also offer a level of inflation protection.

Admittley, there is no guarantee the index will perform as it has in the past, even though the same qualities are present. Still, in an increasingly uncertain world, the FTSE 100’s attractive qualities cannot be overlooked.

The best of a bad bunch

There are no assets that will protect investors' wealth entirely against inflation. The only option investors have is to “choose the mistake that loses you least,” as Merryn Somerset Webb recently concluded. The FTSE 100 might not guard against inflation entirely, but it will almost certainly provide a hedge, and in this environment, that is what really matters.

If the index can replicate its performance between 2016 and 2019 (note, there’s no reason why it will) it could keep pace with double-digit inflation. If it does not, the index currently offers an average dividend yield of 3.65%. That won't beat inflation, but it’s far more than savers will get from their bank accounts.

And while they’ve been somewhat out of fashion due to the general preference for growth stocks in recent years, it’s worth remembering that dividends are a vital component of returns in the long-run.

As the most recent annual Barclays Equity Gilt Study shows, £100 invested in UK equities at the end of 1899 would have been worth just £167 (after adjusting for inflation) in 2020 without dividends reinvested. With income reinvested, the real return would have been £32,025.

As well as its income qualities, the UK market also looks cheap. The market is trading at a forward p/e of 11, around 13% below the 15-year median average.

Tracking the FTSE 100 index will not cost the world

So the market has international diversification, a large allocation towards commodity stocks, an attractive dividend yield and looks cheap – what’s not to like?

The FTSE 100 is also relatively cheap to track. Vanguard and iShares each offer tracker funds that charge just 0.06% a year in fees. That’s important even at the best of times, but in a market where equity prices may only just keep pace with inflation, you really do need to avoid paying any more than you have to – it could be the difference between a positive real return and a real loss.

There are really no good options for investors to own right now, but the FTSE 100 looks to be one of the best of a bad bunch. Investors might want to consider building some exposure to the UK’s blue-chip index as a hedge against uncertainty.