My thoughts on the year ahead for the UK Equity Income investor

Job Curtis, Manager of City of London.

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My starting point is the UK economy where GDP growth is estimated to have been a healthy 2.5% in 2015 and consensus expects 2.4% in 2016 while inflation has stayed close to zero.  The fall in the oil price, from $106 in June 2014 to $43 in December 2015, has helped to reduce inflation and has boosted consumers’ disposable income. Similar economic conditions have been experienced in the US.  Europe is finally recovering, helped by the ECB’s quantitative easing, which started over five years after the central banks of the US and UK engaged in similar unorthodox monetary policies. Emerging markets are mixed, with growth in China slowing, but I remain convinced of the long-term potential of emerging markets as vast populations lift themselves out of poverty and gain a degree of affluence.

Growth on its own is not, in my opinion, sufficient to make stock markets attractive.  The valuation of shares needs to be attractive for investors relative to the prospects.  The average dividend yield of the UK market (FTSE All Share Index) at 3.6% is better than 10 year British government bond yields with a 1.9% yield, 30 year British government bond yielding 2.5% and the yield found on most bank deposit accounts.  But how secure are dividends from UK companies and can we expect much growth?  With over 70% of UK companies’ profits coming from overseas, the economic outlook in the major overseas economies as well as the UK is relevant.  As discussed above, I believe that investors can take reassurance from the overall economic outlook with a possible exception being those commodity stocks highly exposed to weakness in parts of China’s economy.  Already dividend cuts are expected from most of the mining stocks with Rio Tinto being best placed to hold its dividend.  The two large UK listed oil stocks, BP and Royal Dutch Shell, are better placed than some expect to hold their dividends because they have scope to cut their massive capital expenditure programmes and manage them more efficiently.

Turning to the stocks exposed to the UK domestic economy, the housebuilding sector is likely to continue to star given strong demand for new homes and the long land banks that most of the quoted homebuilders have accumulated.  Further special dividends can be expected from housebuilders.  On the other hand, the food retailing sector is likely to remain very competitive given the growth of the hard discounters Aldi and Lidl.  All three quoted food retailers have cut or passed their dividends and a recovery still seems some way off.

One sector that could surprise on dividends is banks.  Britain’s seven biggest banks recently passed the Prudential Regulation Authority’s stress tests.  Mark Carney, Governor of the Bank of England, has said ‘UK banks are now significantly more resilient than before the global financial crisis.’  That being the case, prospects for dividend growth from the leading banks must be improving with Lloyds, in my opinion, particularly well placed to grow its dividend significantly.

I have tried to highlight some of the sectors that are, in my opinion, likely to be the biggest winners and losers in terms of dividends.  Of course, stock selection remains critical in the income area and therefore many investors will be suited to a well-managed, investment trust, backed by revenue reserves.