UK equity income funds could struggle to maintain their current dividend payouts to their investors, according to research by Canaccord Genuity, after the broker warned that the market is facing an “epidemic” of earnings downgrades.
Income-producing stocks have been in much demand over recent years – partly due to ultra-loose monetary policy pushing fixed income investors in equities in light of historically low bond yields – and have been subject to much speculation over when their strong run will come to an end.
In their latest note, Canaccord Genuity’s Alan Brierley and Ben Newell argue that the search for yield is likely to continue “for the foreseeable future” following Bank of England’s suggestion that interest rates might not rise until the first half of 2017.
“However, looking into 2016, we see a more challenging environment for UK earnings and dividend growth, and we note dividend cover in the underlying market has fallen sharply in recent years,” the firm’s analysts said.
“In recent months, we have seen an increasing number of high profile dividend cuts. Meanwhile, although the search for yield has fuelled many years of outperformance by ‘quality defensive’ stocks, it has also impacted valuations.”
Brierley and Newell add that profitability and cash flows are coming under pressure in many areas of the UK equity market, which could mean some companies find it difficult to pay out dividends,
Research by Canaccord Genuity Quest, the firm’s proprietary offering of online analytical tools, valuation models and market commentary, shows that UK large-caps’ total net income has fallen from £171bn to £138bn in the past five years while dividend cover has fallen from 2.7x to 1.6x.
UK large-caps’ dividend cover
Source: Canaccord Genuity Quest
Concern over the future path of UK dividend has increased recently. While companies such as Tesco, Serco, Glencore, Drax and Centrica have made high-profile dividend cuts in the near past, commentators such as the Capita UK Dividend Monitor warn that more could be on the cards.
The latest edition of this closely followed report, which was published in October, warned of a “sharp slowdown” in UK dividends during 2016 and forecast dividend growth of just 3 per cent. It also said a number of companies may cut dividends next year and highlighted Anglo American, Shell and HSBC as being some of the firms that analysts are most concerned about doing this.
Canaccord Genuity’s research supports the view that the coming year could be markedly tougher for UK equity income investors. While some investors are more sanguine about the outlook for UK dividends and argue that the risk of cuts is mainly found in the resources stocks that dominate the FTSE 100, the broker warns that worrying trends can be seen in other parts of the market.
“Yes, energy (aka oils) and materials (largely mining) are down due to depressed commodity prices, but the trend in cash flow returns is also negative in healthcare, consumer staples (i.e. food products, beverages, tobacco and food retail), utilities and telecoms. That’s a big proportion of the market,” the report.
“The only areas of stable returns are consumer discretionary (i.e. leisure, media, retail, housebuilders), industrials (including aerospace, airlines) and information technology, but even here there are plenty of earnings downgrades appearing.”
The below chart shows UK large-caps that have made earnings downgrades (defined as a cut to consensus earnings forecasts of 1 per cent or more over the last 3 months) or upgrades (a rise of 1 per cent or more) for this year and next.
UK large-cap earnings momentum by sector
Source: Canaccord Genuity Quest
The majority of companies in the energy and materials sectors have seen earnings downgrades but the broker says that these aren’t isolated cases.
“It is the extent of the downgrades in other sectors which is more disturbing. The downgrade ratio for telecoms is 80 per cent (only five stocks), 60 per cent in industrials and 53 per cent in financials,” the report said.
“Downgrades also significantly outweigh upgrades in both consumer sectors, healthcare and information technology. So the only sector where there are more upgrades than downgrades is utilities which consists of just 8 companies. Consumer discretionary wins the prize for inertia with 42 per cent in the neutral zone.”
“And it’s worth noting that the stream (or should that be torrent?) of downgrades is not just a sudden realisation that 2015 expectations will not be met. The downgrades are even more severe for 2016. The median downgrade across the whole market is 2 per cent and in most sectors there is a higher proportion of downgrades for [2015] than [2016].”
This casts an obvious shadow over UK equity income portfolios. Brierley and Newell add that they believe open-ended funds are most “vulnerable” to this, as investment trusts can use ‘dividend smoothing’ to manage volatility in underlying income streams.
But not all investors are convinced that UK equity income is in for a difficult ride, with Fidelity’s Michael Clark recently saying that high quality, cash generative and reliable dividend-paying companies such as Imperial Tobacco, AstraZeneca, Reckitt Benckiser and Diageo look poised to continue to deliver for income investors.
However, he warned that mining and energy stocks could be a “dangerous” area of the market for income seekers.
“Where I have question marks is in the commodity sectors. I know we have seen high yields out of the mining stocks this year but I think it’s, broadly speaking, too dangerous to go there as I don’t think those yields will be honoured longer term,” Clark said.
“We don’t have any mining in the portfolio and while we have some oil & gas, these are the safest largest names and even there we are underweight relative to the index. Going forward into 2016, I don’t propose to change that.” 
Schroders’ Matt Hudson (pictured) is also more confident on the outlook for UK dividends and says that dividend growth of up to 6 per cent in 2016.
But in contrast to Clark, he is less confident on the outlook for so-called bond proxies sectors such as the food producers, beverages, utilities and tobacco companies – although he does not expect dividend cuts here – but thinks previously unloved areas like banks will return to being important holdings for income investors.
“The UK stock market has always been a critical source of income and the dividend-paying culture of British companies has a long historical precedent. 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,” Hudson said.
“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 to 6 per cent nominal long-term trend level this year and next.”
