Just a few months ago, forecasts for inflation to reach 3% or more were viewed with some scepticism by many investors. After all, inflation stood at less than 1% and had failed to move to over 3% for a number of years. However, today it stands at 2.3%. Looking ahead, a level of 3% does not just seem possible, but very likely. As such, the FTSE 100's dividend yield could be under threat.
The main cause of higher inflation has been Brexit. It has caused uncertainty surrounding the UK's economic future to rise, which has meant that sterling has weakened. Although the pound has been reasonably steady of late, it is still around 15%-20% weaker versus the US dollar than it was prior to the EU referendum. This means that import costs are on the rise and while retailers have generally been able to absorb them until now, they are unlikely to be able to make sufficient efficiencies to do the same over the medium term.
An even higher rate of inflation than the forecast 3%-and-rising level could be on the cards. Brexit is an unprecedented event, and nobody knows how consumers, businesses and investors will react in future. The UK's economic performance and outlook may have been stronger than people anticipated since the vote to leave the EU, but talks have only just started. As such, the uncertainty seen in previous months which has caused higher inflation could be ramped-up.
Rising FTSE 100
At the same time as inflation has risen, the FTSE 100 has done likewise. Its price level has increased by over 20% in the last year, which has compressed its dividend yield so that it now stands at around 3.7%. While that is 1.4% higher than the current rate of inflation, there is a good chance that the inflation rate could surpass the FTSE 100's dividend yield by the end of the year.
The main reason for this is the effect of Brexit on sterling. As mentioned, sterling may weaken further over the coming months as uncertainty surrounding Brexit negotiations builds. This could push inflation higher. At the same time, weaker sterling is likely to have a positive impact on the FTSE 100's price level.
That's because many stocks in the FTSE 100 are international companies which do a sizeable proportion of their business in currencies other than sterling. If the value of the pound depreciates, then their profitability and valuations could rise. This would push the FTSE 100 higher and lead to yet further compression of its dividend yield.
In time, inflation may exceed the index's dividend yield and leave new investors with a negative income return in real terms. In this scenario, stocks with dividend yields which are still ahead of inflation could become increasingly popular among income-hungry investors.
Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.