The outlook for UK equity income

Market sentiment shifting

Advisers tasked with the creation of income portfolios for clients have, for a decade or more, faced the dilemma of record low bond yields and relatively low equity yields as a result of a combination of sluggish economic growth and buoyant equity markets.

The sluggish growth in the wider economy meant investors were focused on assets that perform well when interest rates are low, so-called 'long duration' equities, also known as growth stocks.

The performance of these equities is linked to interest rates because the market expects those companies to earn far more substantial returns in future than presently.

When interest rates are low, people are happy to buy shares in companies that are growing quickly (such as tech shares) because those companies will make profits in the future, rather than now. Waiting for the future profits is less of a sacrifice when interest rates are low, because the alternative is to hold cash or bonds, which are paying a low return.

However, in a world of high rates, people do not want to own shares that will make money in the future, because they can get more from cash, so that means they buy the shares of companies that make their money now, such as miners.

Such low interest rate market conditions have been particularly painful for UK equity income investors as they require income now rather than in the future. 

But by investing in the shares of the dividend payers, they have had to effectively sacrifice the gains made by the growth stocks, in areas such as technology. 

However, the advent of higher inflation and higher interest rates has meant, since the start of 2022, market sentiment has shifted, with long-duration equities in areas such as technology selling off, and the more value type equities in areas such as mining rising in value.

This has changed the outlook for income investors, as they may be able to achieve both capital growth and a reliable income.  

The FTSE 100 has just four tech stocks at the time of writing, but is replete with companies in areas such as mining, oil, and banking, which would be expected to benefit from this shift in market sentiment. 

Those three sectors account for 40 per cent of the dividends in the UK market right now, according to Tom Moore, who runs the £681mn UK Income Unconstrained Equity fund at Abrdn.

Ian Lance, who runs the £941m Temple Bar investment trust, says: "After many years of strong stock market gains, investors had come to believe that they no longer needed income as they could just harness their capital gains each year.

"Given the record-high valuations in many equity markets, we believe this will no longer be the case and that investors will revert to seeking dividend income. Fortunately the UK market provides lots of opportunities to do this.” 

Sustainable income? 

Many market participants have been wary of investing in those very sectors in recent years due to concerns about the impact of environmental, social and governance factors on their business models, as well as potential technological disruption and regulation. 

But Moore says the recent strong performance of many of the shares in those sectors in recent weeks has not just been about the rotation in markets towards more value-oriented stocks; he says bigger factors are at play, which should boost the long-term income potential of those sectors, which comprise such a large part of the market. 

He says: “ESG has actually helped the oil stocks. For a few years there has been under investment, so supply has been constrained, but what we have seen lately is that, in the UK, fossil fuels are still part of the energy mix, renewable energy is not yet enough. So we have a situation where supply has been constrained, but demand has been stronger than expected, and that is obviously very favourable for the shares and the dividends.”

Of the miners, he notes that the growth of the electric car market is likely to mean demand is strong in future years.

With regard to banks, he says “the era of cheap or free money [via quantitative easing or low interest rates] means that some of the loss-making fintech-type companies that have competed with banks in recent years will struggle. But in addition to that, higher interest rates allow banks to earn more money.”

This happens because banks are required by regulators to retain a portion of their balance sheet assets, typically around 14 per cent, in liquid assets such as cash or bonds. 

For much of the past decade, low interest rates and bond yields meant banks earned little return from these vast pools of capital; as both of those things rise, so does the interest banks receive. 

Moore says the three factors outlined above will be long-lasting, rather than simply a function of a shorter-term shift in market sentiment. 

Lance says: “These sectors are no longer ‘beaten up’, with the energy sector being the best-performing sector both year to date and over the past 12 months, albeit still down significantly over the past decade.

“Secondly, ESG and regulatory concerns have created an opportunity in energy. As many fund managers took a decision not to invest in the sector, the selling pressure pushed share prices down until the sector became very attractively valued.

“In addition, the industry has reduced capital expenditure by 50 per cent since 2013 and created the situation whereby there is insufficient supply to meet growing demand and this has led to record-high prices for natural gas as well as oil prices rebounding. At these levels, the integrated energy companies will produce huge amounts of cash with which to pay dividends and buy back shares even after their investment in renewables.”

He adds: “Banks have undergone a lot of change over the past 10 or 15 years, and for parts of that their balance sheets were not in a position to protect the dividends they pay to shareholders. But the restructuring has now happened, they have taken the costs and they have spent money on updating software systems, but they paid for that by selling some of the businesses they own, and as a result now are in a position where the dividends look more durable.” 

Ken Wotton, who runs the Multi-Cap Income fund at Gresham House, tends not to want to own mining and oil companies in his funds.

He says: “The dividend outlook for those types of companies is very dependent on macro factors such as commodity prices and oil prices, and I am not really qualified to make those calls.” 

Expensive habit

The current yield on the FTSE 100 is 3.5 per cent, which is below the long-term average for the market. 

Although the FTSE 100 outperformed the US market in January, the gains came from just four sectors, the three mentioned above, plus tobacco.

So, has the recent rally in income stocks reduced the opportunity set for clients? 

Simon Young, UK equity income fund manager at Axa Investment Management, says: “It probably has come down for income investors a bit lately. I know some market participants who say that income managers just buy companies for the dividend and nothing else, but I have never actually encountered a fund manager who says they do that. I am quite happy for a company to say that rather than pay a higher dividend, they will invest the cash for growth instead.” 

Young’s fund actually changed its name (previously having 'blue chip' in the title) as he felt some of the companies that have been labelled blue chip in the UK are no longer attractive investments, citing Vodafone as an example. 

He feels such companies, while they pay a reasonable dividend, may not have the potential for growth in the future.

Simon Gergel, who runs the Merchants Trust, says he has been finding fewer income opportunities among the large cap UK stocks, “and about the same number as always” among the mid-cap stocks, and has increasingly been investing outside of the UK in search of new opportunities.  

Chris McVey, who runs the Octopus Multi-Cap Income fund, says the issue with the UK large cap market is the concentration of dividends in a small number of stocks, “and I find there are more income opportunities among the small and mid-cap companies.”

Tim Marshall, UK equity fund manager at Invesco, says: "The FTSE 250 tends to outperform against the FTSE 100 around 66 per cent of the time, but during the recent market turbulence, the small and mid-cap index is in sharply negative territory, while the FTSE 100 has made gains."

Moore says this is because the market is worried that smaller companies have less capacity to protect themselves from higher costs than larger companies and so may have less capacity to keep paying dividends. 

Simon Moon, who jointly runs the Unicorn UK Income fund, which tends to shun the large caps for income and instead buy mid and small-cap companies, says there is a “resilience” to the income in smaller companies as it is more often the case that those companies have significant family shareholders, who are more likely to rely on the dividend for their own income than salaried business executives who are not major shareholders.

McVey says many of the largest companies in the UK market, for example Shell and BP, were “overpaying”, that is, having dividends that were unsustainable. He feels the pandemic allowed those companies to cut their dividends to more rational levels, and investors should expect this to be the normal level in future.   

Alternatives 

A feature of the market over the past decade has been the rise of alternative income investments, in areas such as music royalties and aircraft leasing, as investors move away from low bond yields. 

There are multiple challenges for an adviser seeking to allocate to these types of assets. The first is that while the underlying revenue streams of those types of companies are likely not to be correlated to wider economic conditions, those assets are relatively new, and there is not numerous years of data for investors to examine on their performance.

In addition, when considering the diversification potential, while the underlying income stream may not be linked to the wider economy, the investment vehicles in which these are held are listed on the stock exchange, so one would still be exposed to the usual equity market risk. 

James Barton, chief executive at Featherstone Investment Management, is keen on such assets to the extent that they have replaced any bond allocation in client portfolios. 

James Burns, who runs the model portfolio service at Smith and Williamson, says alternative income investment trusts in areas such as student property are attractive right now, but carry the same sort of volatility levels as do wider equity markets, demonstrating that there is “no perfect investment vehicle.”