Sterling boost masks uncertain outlook for UK dividends
The dividend outlook for the UK remains mixed. Dividend cover for the overall market has fallen over the last few years with corporate growth under pressure from a patchy economic backdrop. Debt levels have also been rising, as companies have used low borrowing costs to help fund acquisitions and share buy-backs.
Offsetting these factors last year was the significant depreciation in sterling, which is helpful for UK companies that earn and/or pay their dividends in foreign currencies. This led to a modest increase in market dividends last year, but without this currency benefit dividends would have fallen.
As it stands, 2017 is likely to be a similar year with a difficult dividend backdrop being offset somewhat by the continuing flow-through of currency tailwinds.
Dividends need stimulus
In terms of the Evenlode fund, the first three interim dividends for the year ending February 2017 were increased by 3.6% and we expect a similar growth rate for the full year. More generally, our focus on providing real dividend growth over the medium and long-term remains central to our approach.
I continue to feel that mid-single-digit dividend growth is probably as much as can be expected in the current environment, even from the cash generative businesses we focus on. A higher growth rate is unlikely unless the global economy and/or inflation were to pick up materially.
Looking ahead to 2017 plenty of uncertainties await, not least on the political front: Donald Trump is now US president, there will be several important European elections and Brexit negotiations will continue.
While the market has begun to anticipate a pick-up in global economic growth and inflation in recent months, structural deflationary pressures remain significant and should not be ignored. In particular, even a small rise in interest rates could cause problems for economic progression given the high stock of global debt.
Return horizon narrows
Turning to valuations, future returns appear less attractive than they did several years ago (and many stocks that are ostensibly ‘cheap’ on a price/earnings basis carry significant fundamental risk such as high levels of debt and a lack of cash generation). We continue to nudge the portfolio gently towards where we see the most attractive combination of quality and long-term valuation appeal.
Market’s weakening balance sheet
A characteristic we have been particularly focused on over the last three years is balance sheet strength, given an overall environment in which many companies have been taking on more debt (making them more vulnerable to negative economic developments and/or interest rate rises).
More generally, our aim remains to insulate investors from a wide range of political and economic outcomes rather than make big predictions. On this note our focus as we head into 2017 will as usual, be on asset-light companies with sustainable competitive advantages.
Hugh Yarrow is co-fund manager of the Evenlode Income fund