What a difference a year makes. UK dividends finished 2021 in notably better shape than in 2020, and that strength has – perhaps surprisingly – continued into 2022, with underlying growth of 12.2% in the first quarter.
It has also been a far stronger period for equity income strategies more generally, topping the performance charts over the past six months. Have UK dividends finally turned a corner or are there vulnerabilities ahead?
Commodities remain the heavy-weight
The most recent Dividend Monitor from Link Group painted a rosy picture of the UK equity income sector. It says underlying payouts are likely to be £85.8bn, 11.1% higher than 2021. This stronger outlook, plus a shift in market sentiment away from low-dividend growth stocks towards dividend-paying value areas such as energy, mining and financials, have helped boost the performance of equity income funds.
IA UK Equity income is the top performing sector over the last six months, after Latin America, commodities, infrastructure and commercial property.
This suggests the worst may have passed for UK equity income after a dismal few years. However, there are reasons for some caution. Dividend growth is still heavily dependent on commodities. In the first quarter of 2022, dividends from the oil sector led the way, rising 29% year-on-year to £2.2bn. The boost from the mining sector – which delivered dividends of £20.96bn in 2021 – is also likely to continue with bumper payouts expected in the second quarter.
Other sectors have stepped up. Healthcare and pharmaceuticals, for example, rose 16% to £3.2bn. However, this was largely attributable to an increased payout from Astrazeneca following its acquisition of Alexion. The retail sector also saw strong growth, albeit from a very low base, rising 268% to £584m. Telecoms also saw some recovery as BT resumed its dividend after a two-year hiatus. The problem is that none of these other sectors could fill the void left by the commodities sector were soaring commodity prices to reverse.
Equally, some of the sectors that have seen strong growth – such as the retail sector – look vulnerable to a changing market environment. The UK is facing a cost of living crunch, with disposable income falling by the largest amount since the 1950s. Many of the other consumer sectors – basic consumer goods, travel and leisure, housebuilding – already look relatively weak compared to last year. This paints a picture where dividends are driven higher by cyclical or one-off factors, with precious little structural growth.
Buybacks becoming ‘de rigueur’
Louis Coke, senior investment manager at Charles Stanley, also highlights another problem with UK dividends. He points out that larger companies are showing an increasing preference for US-style share buybacks as a means to return surplus cash to shareholders rather than paying higher dividends. Many companies are pursuing multi-billion dollar programmes, including Shell, BP, and HSBC. He adds: “The UK has had a cultural emphasis on cash dividends, but we are seeing more share buybacks.”
According to analysis from AJ Bell, nearly £33bn of share buybacks was announced in the first quarter of 2022 by members of the FTSE 100. This means they are on course to break pre-pandemic full-year records after just three months. Twenty-nine FTSE 100 firms have already declared new buyback programmes in 2022 compared to 30 in the whole of 2021. This may help share prices in other ways, but it could stymy dividend growth.
See also: Equity income managers size up UK’s buyback bonanaza
‘Lots of change tends to be good for smaller businesses’
However, this is not as much of a problem further down the market capitalisation scale. Bloomberg data shows that FTSE 250 companies spent just £1.8bn on buybacks between 1 January 2022 and 15 March 2022. It is also worth noting that dividend growth was far stronger among mid-caps (30%) than the top 100 (13%), with growth among smaller companies faster still. This builds on the success in 2021, when mid-cap dividends rose twice as fast as large cap dividends. There are vulnerabilities for some of the retail names in the mid-caps, but the sector as a whole looks more robust.
At the same time, the FTSE 250 and FTSE Small cap indices have underperformed the FTSE 100 over the past 12 months. The FTSE 250 is up just 0.5%, compared to a return of 16.1% for the FTSE 100 in the year to 31 March. Small caps are up 5.3% over the same period. Coke says: “When we look below the FTSE 100, we find some interesting opportunities. There is lots of change happening and that tends to be good for smaller businesses. The barriers to raising capital have also gone now and we see some great ideas coming out of management teams.”
Christopher Applin, senior portfolio manager at Mirabaud Wealth Management, believes that equity income strategies still have an advantage over fixed income, even as bond yields rise. He says that the group’s equity income strategies have tended to hold up better than other areas during the recent market rout. He also believes there may be more recovery to come for dividends. Nevertheless, selectivity is vitally important.
It has undoubtedly been a much better period for UK equity income. However, there are still cracks – an over-reliance on certain sectors, for example, and a lack of visibility on future growth. Given the recent share price underperformance, but ongoing dividend resilience, there are likely to be more opportunities in the mid and small cap sector looking at the year ahead.
