Outlook 2018: UK equity income
A flexible and pragmatic approach will be required as strategies which have been effective over the past five years may be less likely to perform in the next few years.
We base our perspectives on the potential for UK equity income in 2018 on three interconnected themes. Firstly, one for the record books. In 2018 we expect that the UK equity market will produce circa £101 billion of dividends, the highest ever nominal sum and equivalent to a yield of circa 4% based on the current market cap of the FTSE All-Share.
This record amount of income includes both “special” dividends, which are often one-off in nature, but also "scrip” dividends which are effectively capital in nature as investors forgo their cash income and receive new shares instead. Over the last few years, scrip dividends have been a small but growing part of the market, especially among high yielding large cap stocks such as HSBC and Royal Dutch Shell. While there are often good reasons to offer a scrip alternative, in some cases they have been used to avoid cutting the nominal dividend. Excessive use of this mechanism can lead to trouble.
Growth has outperformed value
While at the market level, the dividend yield is around the long run average for UK equities, the composition of the dividend by stock and sector, the divergence of lower and higher yielding stocks, is as wide as I have seen it for nearly 20 years. A related issue is that the “quality” or sustainability of this distribution has been eroded as well over this business cycle, with dividend cover (a crude estimate of sustainability) retreating to recessionary levels last year.
This reflected in part the collapse of commodity prices in 2015 which left dividends in the important oils and mining sectors (together over 20% of all UK dividends) uncovered by profits and most importantly cashflows. However, it was also caused by an investor obsession with dividend payments at odds with the fundamental income generating capability of some businesses. Conditions have improved over the last 12 months or so but there are more high yielding, lowly covered dividends than usual for this stage of the cycle.
So despite the defining market narrative that investors are seeking income in a low interest rate world, higher yielding equities have struggled. “Growth” stocks have significantly outperformed “income” stocks over the last three years. The compound total return from a basket of the highest yielding stocks has been 24.2%1 since the start of 2015 while a similar basket of lower yielding equities has delivered 29.2%2 .
Secondarily, although the £100 billion-plus dividends expected to be declared in 2018 is an all time high, the rate of dividend growth is likely to be lower in 2018 and 2019 than it has been over the last few years. This partly reflects the fact that we are in the late stage expansion phase of the cycle, but is mainly due to the big rise in the sterling value of non-sterling dividends.
Over 40% of the UK dividend base is declared in non sterling currencies with US dollar dividends being the vast majority. As sterling moved to a new low against the US dollar in 2016, the domestic value in sterling of these dividends rose substantially, creating a headwind to future dividend growth. In 2016, dividend growth excluding specials and the benefit of currency was probably about zero.
Traditional income stocks out of favour
The third theme is the most interesting and potentially the most challenging for income investors. This long cycle, in which nominal economic growth has been low and inconsistent, interest rates stayed at risk bottom levels and inflation has failed to return, has been dominated by the performance of long-duration stocks3.
While equity markets have favoured risk assets and value stocks every couple of years or so, the dominant theme, the winning style has been growth - as represented most obviously by US tech stocks and anything that exhibits a bond like low volatility. Equities that exhibit steady growth, without recourse to major capital investment have been the winners, while the losers, especially domestically facing businesses, have been consistently punished by the market. The premium achieved by the winners over the losers has been staggering.
This has left the UK market with a large pool of generally lowly valued, higher yielding and, very importantly, underperforming stocks - pub companies, selective support services, domestic utilities, retailers and anything that does not fit into the market’s current narrative of what “good” looks like. In part, the market has lost perspective on slow-moving incumbent businesses as it focuses on technological change.
To misquote Bill Gates, investors always overestimate the speed of technology change but underestimate the impact over time. This certainly seems apt for the current market. Those stocks and sectors out of favour with the current focus on growth are often traditional income stocks, unlike during the technology, media and telecoms (TMT) period. During the TMT period value and income assets were derated but their profits were rock solid, now investors need to consider the sustainability of profits and dividends.
Flexible and pragmatic approach
While future growth is an alluring prospect, in my experience, income investors are interested in cash now and cash in the future. We estimate that UK dividend growth, excluding special dividends will be slightly above inflation but below the long term nominal rate of circa 6%. However the strategies that have been effective over the last five years - quality growth, small/mid cap skew, are less likely to perform in the next few years and what will matter most is a flexible and pragmatic approach to achieving a premium yield over the cycle.
The challenge is finding companies that can sustain a high premium yield to the market and to deal with the idiosyncratic nature of the UK dividend base. A detailed knowledge of the UK dividend landscape and a top down recognition of the cycle will be key to success.
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1. Source: Bloomberg. FTSE 350 Higher Yield index, total return close 31/12/14 to close 30/11/17. ↩
2. Source:Bloomberg. FTSE 350 Lower Yield index, total return close 31/12/14 to close 30/11/17.↩
3. Equities that exhibit the same defensive characteristics as bonds.↩