As well as providing attractive double-digit capital gains in 2017, the UK equity market also provided handsome income growth for many investors. UK dividends jumped 10.5 per cent to £94.4bn, a record high. The UK’s strong dividend growth reflected significant increases in payments from mining companies, sterling’s weakness and a plethora of special dividends.
Even when excluding special dividends, underlying dividends grew at the fastest rate since 2012, with miners accounting for nearly half the increase.
For example, Rio Tinto sharply increased its dividend and Glencore paid its first dividend since August 2015. Weaker sterling was broadly beneficial for dividend growth, given approximately 40 per cent of UK dividends are paid in dollars.
Dividend growth
Strong growth in dividends from mid-cap companies also provided a boost, with mid-cap dividends rising significantly faster than the FTSE 100 (14.6 per cent vs 10 per cent) helped by generous distributions from house builders and leisure stocks. This trend is likely to continue as mid-cap dividend growth is forecast to exceed that of the large-cap FTSE 100 in 2018, but the yield on large-cap stocks will continue to exceed that of mid-caps.
Last year’s strong rise in dividends is unlikely to be repeated this year with current forecasts suggesting 5 per cent dividend growth. 2018 dividend growth is likely to be more sluggish than2017 for at least two reasons: namely the rebound in the sterling exchange rate and the likely drop in special dividends.
With 40 per cent of UK dividends paid in dollars, we believe currency alone (at a current exchange rate of $1.41) could potentially strip 4 per cent off 2018 dividends. Meanwhile, special dividends are also likely to be less plentiful in 2018, hit by an expected slowdown in the domestic economy due to Brexit. Despite this, UK-listed companies are well positioned to fund some dividend growth.
Key points
- In 2017 the UK equity market offered good income for investors
- In 2018 the UK life insurance industry offers good value
- Between now and 2020 the UK market has priced in three interest rate hikes
News flow on Brexit negotiations has become incrementally more positive and FTSE All-Share companies generate around 70 per cent of their revenues from overseas.
Moreover balance sheets remain strong. The FTSE All-Share average net debt to earnings before interest, taxes, depreciation, and amortisation (Ebitda) is forecast to decrease for a third year in a row, down 20 per cent from 2016 to 2017 and a further fall of 15 per cent (to 1.4 times) forecast in 2018. Such deleveraging, during a period of growing dividends, points to strong cash generation and suggests shrewd management teams, keen to protect dividend payments.
In terms of sectors to watch, the UK life insurance industry continues to offer good value and income growth. The sector has a historic dividend yield of 3.8 per cent, protected by a dividend cover of approximately two times.
Lifetime mortgages
We have seen particularly strong growth in the lifetime mortgage market, dominated by the likes of L&G, Aviva and Prudential, with approximately 40 per cent growth in 2017.
The social benefit of these products should leave them relatively well insulated from increasing regulation and should facilitate continued dividend payments from the companies that sell these products.
The UK banking sector is another sector to watch, which should benefit from a rising rate environment. As central banks begin to wind down extraordinary monetary stimulus measures, there should be an opportunity to increase profitability. Investors should keep an eye on the spread between what interest rate banks pay to customers on deposits compared to what interest rate they charge on loans. The lower the “pass through” to deposits achieved, the greater the positive impact to net interest margin. This should support shareholder returns.
The UK market has currently priced in three rate hikes between now and 2020, which could provide opportunities for structurally sound UK banks to positively surprise the market.
With a yield in line with the market and strengthening dividend cover, the UK banking sector appears to offer a potential buying opportunity. This sector and the UK life insurance industry are just two examples of the significant opportunities on offer for those investors who remain undeterred by the UK equity market, which is currently one of the most unloved equity markets globally.
On a price-to-earnings basis UK valuations are at the bottom end of their recent range. In addition, the UK equity market is forecast to be the highest yielding equity market globally – again – with a dividend yield of about 4 per cent.
For those investors concerned about the sustainability of dividend growth, investment trusts may be worth a look.
Investment trusts
Investment trusts (or closed-end funds) can tuck away up to 15 per cent of their income, in any one year, into revenue reserves. This provides a pot of money to pay dividends from in more lean times.
Investors looking for greater security of equity income might want to consider investment trusts which have large revenue reserves. Substantial reserves can provide a very significant safety buffer in more difficult times and gives greater certainty to the payment of future dividends.
William Meadon is co-manager of the JP Morgan Claverhouse Investment Trust
