Optimistic signs for UK dividend growth

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.

If sterling strengthens relative to overseas currencies, pressure will mount on these companies’ earnings, and consequently on their dividends.

One topic that will have a significant impact on the level of sterling is the possibility of a Brexit. This debate, which could last up to four years, will be a source of uncertainty for the currency. This lack of clarity could also weigh on sterling, a potential positive for firms with substantial overseas earnings.

Companies with strong business models, good management and high barriers to entry are often well-positioned to provide better, long-term dividend streams. However, in today’s slightly tougher environment for equity dividends, investors seeking income in the UK market can look beyond stocks and towards inflation-linked bonds.

Inflation should rise on the back of two factors: as a result of the base effects of the low oil price dropping out, and due to the impact of the government-mandated switch from the minimum wage to the new national living wage this year.

Although bond yields are low, these inflation-linked bonds are designed to counter the eroding effects of inflation as their income from coupons and redemption payments are linked to the Retail Prices Index. Therefore, a combination of dividend-paying equities and inflation-linked bonds is a good way to generate income in a portfolio while interest rates remain low.

Richard Marwood is manager of the Axa Distribution fund

UK DIVIDENDS: Q3 2015 NUMBERS

£27.2bn

Total UK dividends paid

30.8%

Headline growth in UK mid-250 company dividends

£2.9bn

Total dividends paid by mid-250 companies

Source: Capita UK Dividend Monitor, October 2015