Equity Income  

Rising valuations stoke caution but sterling weakness to support sector

This article is part of
Fund Review: UK Equity Income

Rising valuations stoke caution but sterling weakness to support sector

UK equity income funds have historically been popular among UK investors, as the asset class has typically provided a decent level of yield. Additionally, a number of well-known managers run outperforming UK equity income funds, helping to boost the sector’s popularity.

But will rising valuations prompt investors to leave the asset class? Certainly, net retail sales of the Investment Association UK Equity Income sector have slowed in recent months. The figures show net retail sales peaked at £342m in April this year, followed by outflows of £310m in June, the month of the EU referendum, and by September net retail sales had fallen to just £17m.

It’s a similar story for UK equity income investment trusts, where discounts have been widening.

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According to research by Stifel, the sector has “fallen out of favour” in the past couple of months, with many trusts moving out to their widest discount levels for more than five years.

For example, Schroder Income Growth is on an 11 per cent discount, which compares with a one-year range of 3 per cent to 12 per cent. JPM Claverhouse is also on an 11 per cent discount, against a one-year range of 11 per cent to 0 per cent.

Stifel suggests: “We think there has been some profit-taking and wariness on the part of investors to invest in the sector, with the FTSE 100 recently reaching an all-time high.”

It adds: “Many of these trusts are underweight the mining and oil sectors – this helped the Equity Income sector’s relative performance to the FTSE All-Share index in 2014 and 2015. However, with these sectors performing strongly in 2016 it does mean that many of the UK equity income trusts have underperformed [this year].”

Hugo Ure, manager of the Troy Income and Growth Trust, observes one trend among UK equities that took place after the Brexit vote. “Through the Brexit period, those companies that had a slightly bond proxy-like nature performed very well, as bond yields came down. We’ve lost the edge of that as bond yields have bounced back.”

But he also notes: “Dividends have been growing for the market at a faster rate than earnings have and that’s not 100 per cent sustainable. We had a lot of dividend cuts last year and at the beginning of this year, with BHP Billiton and Rio cutting their dividend. 

“With the exception of Centrica, we didn’t own any of those 15-16 companies that cut their dividends but we were aware there was a pressure on the market dividend. This year, the weakness of sterling has had a major impact on UK dividends.”

Looking ahead, the implications of a ‘hard’ Brexit, which prime minister Theresa May has indicated she will be negotiating for, are not entirely clear.

Whitechurch Securities suggests: “For our UK exposure it will come as no surprise that with the Bank of England moving interest rates lower, our favour for dividend-producing UK stocks is reinforced. 

“In the uncertain climate, it makes sense to look towards overseas earners who are benefiting from sterling weakness and quality businesses that can grow dividends despite the climate. However, we also believe that there is merit in small and mid-cap UK companies but the key is to find stockpickers who can unearth these gems at reasonable valuations.”