The UK equity market has traditionally been a strong source of income for investors as companies offer a portion of their annual earnings to shareholders in the form of dividends.
Cosmetically, the equity market looks better than the bond market since the yields on dividends are typically higher than bond yields in the current low interest rate environment.
But one of the key concerns that emerged last year is the sustainability of companies’ payouts.
Dividend cover – which is a ratio indicating how many times over a company could pay its scheduled payout out of its net income – across UK equities listed on the main market has continued to decline in the past six months, reaching 1.67 times from 1.78.
The cover on UK equities is now at a 20-year low, which is largely related to the slump in commodity prices in 2015, putting severe pressure on earnings in the oil and mining sectors.
As a result, dividends have come under pressure and in some cases have been suspended altogether.
Mining firm Glencore is one of the notable dividend casualties as prices for its key products – copper and coal – have fallen markedly. In other sectors, Tesco and Morrisons have had to adopt more conservative polices as supermarket price wars have taken their toll, while the emerging markets-focused bank Standard Chartered has cut payouts.
However, it’s not all doom and gloom in the UK equity market. The headlines of falling dividends are driven by commodity-related companies, but beyond this there are positive areas.
Some firms have still been able to increase their dividends at healthy rates through these tough times, such as BT, Imperial Tobacco, Whitbread, Pennon and Legal & General.
The positive areas are evidently more a case of company specifics rather than sector specifics. In addition, the majority of the dividend gloom is concentrated on the larger firms. Mid-cap stocks continue to show dramatically faster growth in payouts as they are generally not as exposed to the negative trends across the global economy.
The trends of commodity prices and market cap will continue to shape movements in the UK equity dividend market. The sustainability of UK payouts will remain a hot topic this year, especially in the context of the path of commodity prices in the next 12 to 18 months.
If we stay at such low price levels, commodity-related companies will continue to face very tough decisions on costs and payouts.
Meanwhile, dividend growth is expected to be negative for FTSE 100 companies in 2016 at -1 per cent, compared with the FTSE 250 index, which is expected to grow at 6.7 per cent.
So there is plenty of income growth available in the market, but fund managers needs to be very selective and look at the underlying company fundamentals to evaluate the sustainability of payouts.
The level of sterling will also influence the future of UK dividends. Several large multinational firms such as British American Tobacco, Diageo and Vodafone rely heavily on their overseas earnings.