UK dividends could be poised for strong growth in the near term, according to Schroder UK Alpha Income fund manager Matt Hudson, who is expecting a recovering banking sector to help lift total payouts in the market. 
Hudson’s comments offer a positive voice after the latest UK Dividend Monitor from Capita Asset Services warned that income investors could face a more difficult 2016, suggesting total dividends in the UK could grow by just 3 per cent next year.
Capita’s preliminary forecast is that £89.8bn will be paid out in dividends next year, up from the £87.2bn it is forecasting for all of 2015. Although headline dividends are expected to grow by around 6.8 per cent in 2015, next year is tipped to be slower because of potential cuts – especially in the commodities sector – and the impact of a less strong dollar.
Following on from this, FE Trustnet looked at which funds rely the most on BHP Billiton, Rio Tinto, Anglo-American, BP, Royal Dutch Shell and HSBC – the stocks deemed by Capita to be most at risk of cutting dividends – to generate their income payouts.
We found that 66.61 per cent of IA UK Equity Income funds hold at least one of those five stocks in their top 10 while more than one-quarter have major positions in the three or more.
Source: FE Analytics, Bloomberg and Miton
However, Hudson is more sanguine in his outlook and expects dividend growth of up to 6 per cent in 2016.
“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,” he 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.”
Hudson says that domestically-orientated banks are currently one of the most interesting UK equity income prospects in the market.
Over recent years banks have been rebuilding their capital and the consequences of the global financial crisis mean that more attention is being placed on business activities offering higher returns, less volatility and on lower capital requirements, such as retail and commercial banking, than investment banking.
The manager argues that banks have “a lot of potential lost ground to recapture” when it comes to their share of dividends paid out. In 2005, payouts by banks accounted for more than one-quarter of the UK’s total dividends but this now stands at an estimated 13 per cent for 2015.
Proportion of UK equity market’s dividends accounted for by the banks
Source: Schroders
“We favour Lloyds and Barclays as they continue to turn the focus back onto their retail and commercial operations, and see new opportunities in a range of smaller ‘challengers’, which offer both growth potential and attractive yields,” Hudson said.
“When we move to a higher interest-rate environment we expect this to be a positive for the sector. Meanwhile, after enduring intense scrutiny from regulators in the past few years, the banks now enjoy much-improved capital positions. The strengthening of their balance sheets should ultimately allow a greater proportion of earnings to be returned as dividends.”
Indeed, Capita cited Lloyds’ recent interim payout – the bank only returned to the dividend list at the start of 2015 – as one of the reasons why UK dividend growth hit a record high in the third quarter; it has also pledged a final distribution by the end of the 2015.
The example of Lloyds also offers hope that Royal Bank of Scotland, the other bank to be bailed out by the taxpayer at the height of the financial crisis, could prioritise dividend payouts as part of its “rehabilitation,” Hudson said.
When it comes to Barclays, the manager notes that new executive chairman John McFarlane said 2015’s total distribution per share would be held at 6.5p.
However, he expects progressive payments to resume once McFarlane’s restructuring plans – which involve a move back to its core business of lending to small and medium-sized companies and mortgages and away from growing the investment banking franchise – begin to take effect.
Lloyds Banking Group is the fifth biggest holding in Schroder UK Alpha Income with a 3.7 per cent weighting, while the 3.2 per cent allocation to Barclays makes it the ninth largest stock. Financials is the largest sector allocation at 31.5 per cent, overweight both its FTSE All Share benchmark and its peer group average.
But Hudson has a more cautious view on so-called bond proxies sectors such as the food producers, beverages, utilities and tobacco companies, where valuations have rocketed since 2007 after investors flocked to them for their perceived relative safety and attractive dividends.
While he is not expecting dividend cuts here, the manager warns that their futures are likely to be much more challenging.
“Many of them have rerated to their highest level in two decades, but this super-charged performance appears to have run its course,” he said.
“We witnessed the first inklings of this at the start of this year, when many of these companies stopped outperforming before bond yields troughed. The prospect of a rise in interest rates has begun to set the agenda and while some of these companies may be growing earnings at 8 to 9 per cent, the period of extra-strong returns related to declining bond yields has passed.”
Hudson has managed the £643.6m Schroder UK Alpha Income fund since its launch in May 2005. Over that time, it has made a 139.48 per cent total return, ranking it seventh of 45 funds in the IA UK Equity Income sector and beating the 107.59 gain in the FTSE All Share.
Performance of fund vs sector and index since launch
Source: FE Analytics
The fund is run using the business-cycle approach that was developed at Cazenove Capital Management before its acquisition by Schroders. This means that it aims to adapt to market changes by moving between sectors, buying more defensive businesses before conditions turn tougher and adding cyclical stocks as a recovery takes hold.
Schroder UK Alpha Income has a clean ongoing charges figure of 0.91 per cent and yields 4.33 per cent.
