UK dividend income poised for recovery
As we move into the latter phases of the business cycle UK dividend growth looks likely to accelerate again. Matt Hudson, who heads up the Business Cycle Team at Schroders, explains what is driving this dividend recovery.
UK equities - income generators
The UK stockmarket has always been a critical source of income and the dividend-paying culture of British companies has a long historical precedent.
This culture is clearly underlined by London Business School data that shows how the 5.2% average annual real return generated by UK shares between 1900 and 2012 would have been just 0.6% in the absence of dividends.
Companies remain squarely focused on growing shareholder distributions, a trend which in this low interest-rate environment is being taken ever-more seriously at the board level.
It should therefore be unsurprising that the UK equity market is an important income generator not just for domestically based investors with a home bias, but international ones too, who are looking at its attractions from a European or global perspective.
The above-cited London Business School data also underlines how long-term investors who benefit from the compounding effects of reinvesting dividends enjoy far superior returns.
The capex cycle should really fire if we see synchronised growth in Europe and the US. This would be a big driver for dividend growth.
And underpinning the strength of the UK equity income investment thesis is the market’s track record of delivering progressive distributions in excess of the rate of inflation (with long-term nominal dividend growth of 5–6% over the business cycle).
After a hiatus in 2013, UK dividend growth looks to be accelerating again in 2015.
This reacceleration is what you would expect as we move into the latter phases of the business cycle, and we anticipate dividend growth returning to its 5-6% nominal long-term trend level this year and next.
The below graph illustrates how UK dividends as a whole have rebuilt following the financial crisis and recession of 2007/08.
Rather than the total amount of dividends paid by UK equities, which surpassed the prior peak a few years ago, the graph shows the like-for-like payout at the per share level.
It adjusts for the huge issuance in new stock which occurred in the aftermath of the financial crisis, and underlines how the market is on the cusp of recapturing the peak payout levels achieved before the downturn.
The UK market generates around £80 billion of dividends every year, so it’s a very deep pool in which to invest for income.
The range of opportunities is wide, from large-cap companies which offer high dividend yields to many small and medium-sized firms with exciting dividend growth potential.
In a period when yields on bonds have fallen so far (the 10-year gilt yield stands at 1.75% at the time of writing), the UK equity market will remain an important asset for those who require income today.
Arguably, this is truer for UK equities than any other developed market, as they have historically offered higher yields.
But one of the knock-on effects of the current low-return world is that safer higher-yielding equities have performed very strongly since 2007, these are the so-called ‘bond proxies’, or long-duration stocks, which include:
- Food producers
- Tobacco companies
Many of them have rerated to their highest level in two decades, but this super-charged performance appears to have run its course.
We witnessed the first inklings of this at the start of this year, when many of these companies stopped outperforming before bond yields troughed.
The prospect of a rise in interest rates has begun to set the agenda, and while some of these companies may be growing earnings at 8-9%, the period of extra-strong returns related to declining bond yields has passed.
Exciting growth potential
While we have concerns about some of the high-yielding companies, this caution is more than compensated for by those firms offering the potential for strong dividend growth.
Indeed, if you can find a stock that offers a decent real yield, which is sustainable over time, you should have an excellent investment.
We are in the latter stages of the business cycle and, as you would expect at this stage, dividend growth is beginning to reaccelerate. However, this cycle has two key differences to previous cycles:
- Wage growth has been much slower than you would have expected at this point and given how long we are into the recovery.
- The capital investment (capex) cycle has not yet swung into action. That is the point at which companies judge that demand is sufficiently strong to start investing.
There have also been unique challenges posed by last year’s Scottish Referendum, the UK general election in May and the dramatic decline in energy prices.
The prior two events served to delay the cycle as multi-national and domestic companies waited for more certainty regarding the political landscape, and as a result capex has rolled slowly off since 2013. But this is beginning to change.
Looking forward, the capex cycle should really fire if we see synchronised growth in Europe and the US. This would be a big driver for dividend growth.
If you believe in a synchronised recovery and the world economy moving into more of a reflationary stage, the UK equity market is packed full of companies which should perform well in such an environment - including selected Financials, Commodity Cyclicals and Consumer Cyclicals (see ‘The seven style groupings of the Business Cycle equity team’, below).
The banks are one of the most interesting areas for UK equity income investors, particularly when you consider that in 2005 they paid on aggregate around £13 billion of dividends, equivalent to approximately 26% of the equity market’s total distributions that year.
This year we expect UK banks to be paying about £11 billion, around 13% of the total, and half the peak level reached in 2005, so the recovery potential is clearly significant (see ‘Banking dividends have significant lost ground to recover’, below).
The European Union in/out vote does add an element of uncertainty, but we believe that the market impact of the result will be relatively short-term.
Having been through the Scottish Referendum and UK general election so recently, investors are now very familiar with some of the key sensitivities around the capex cycle.
It will have some impact from the key market everyone looks at, financials, but the financial system in the UK has been very adaptive to different tax regimes, different regulatory regimes, and will continue to evolve whatever the outcome of the poll.
Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.