As the ramifications of the global lockdown response to COVID-19 develop, dividend income is being slashed. Boards are cutting dividends in response to commercial and regulatory pressure, as corporates batten down the hatches. We explore what this means for our clients, especially those who need a regular investment income, and consider how long and severe this income drought might be.
When the Coronavirus initially hit the headlines in January, equity markets reacted indifferently. Unfortunately, COVID-19 rapidly accelerated into a global pandemic and it became evident that significant damage was going to be inflicted on the global economy.
Equity markets reacted to this realisation with unprecedented speed, as the bellwether US S&P 500 index moved into bear market territory (falling more than 20%) faster than ever before. While the fall in capital values of equities is alarming for investors, the impact of the crisis on portfolio income will be the main concern for those who rely on it.
We can look at what happened to dividends in past downturns for context. The last two global recessions occurred in 2000, as the dot-com bubble burst at the turn of the century and in 2008, with the global financial crisis (GFC). During the dot-com episode, UK dividend income fell by around 18%, compared to a reduction of 12% for US and European dividends. This difference, in part, reflects the larger proportion of UK earnings paid out as dividends compared to other markets around the world. This characteristic makes UK shares attractive to income-seeking investors but does leave the market more vulnerable to dividend cuts when companies are hit by recession.
The global financial crisis was more serious for dividend investors. Originating in the financial sector, a broader recession in which companies of all kinds were caught ensued, despite bailouts for banks around the world. Dividend income declined by around 30% across the UK, US, Europe and Asia. It is also worth remarking on the length of these dividend downturns, which were longer than some of the accompanying downturns in share prices. It took about two years between the first drop in dividend payments and the low point. It then took at least a further two years for dividends to recover, and for some markets this recovery took four years or longer.
What we are facing today will likely prove to be quite different from these previous events, as lockdowns in place around the world prevent populations from consuming (and producing) in the way they normally would. Some industries, such as airlines, face an unprecedented zero-level of business, until more normal life resumes. The impact on company earnings (and therefore dividends) is dependent upon how long the lockdowns continue, which remains unknown. Companies are beginning to cut dividends to preserve cash as a result of this uncertainty, so what is the market discounting in terms of magnitude of these reductions?
There are futures contracts which allow investors to speculate explicitly on the level of dividend income from several major indices, so we can quickly observe what these markets are telling us. These contracts in respect of the UK's FTSE 100 index have fallen around 59% since the start of the coronavirus crisis (20 February – 6 April). The equivalent figure for the Eurostoxx 50 (an index of the 50 largest companies in Europe) is 55%, and for the S&P 500, it is 32%. The magnitude of these falls is investors’ collective best estimate of the fall in dividend income for these markets in 2020. This is a useful indicator, but information contained in their prices may not be as accurate as we would like.
Turning our attention to the UK, we note that at current prices the stock market has a dividend yield of around 5.5% on a historic basis (based on the last 12 months of payments). This compares to an average of around 4.2% over the last 50 years. One way we can interpret this increase, is that markets are expecting dividends to be cut, and if they were to fall back to their long-term average, that would represent a fall of 24% on last year's level of income.
If we divide the UK equity market into its constituent sectors, we can see that expectations on this basis vary considerably by industry. Some industries discounting larger levels of dividend cuts are materials, energy, financials, consumer discretionary and consumer staples. There are intuitive reasons why these sectors could come under the most pressure in a downturn. For example, materials is a highly cyclical industry and reliant on demand from China. Furthermore, consumer discretionary shares will be hit as shoppers stay away from high streets.
However, the biggest contributors to UK dividends are from energy and finance sectors, which together comprise nearly 50% of total dividends. Oil prices have fallen to historic lows following the break down in cooperation between OPEC and Russia leading Saudi Arabia to increase supply. Clearly there is a close relationship between oil prices, earnings and the ability to pay dividends of the big oil companies. Our analysts see little risk of dividends being cut in the short term, as these companies will do their utmost to maintain their payments, but a recovery in oil prices is required for security of the dividend over the medium term.
In the finance sector, we have recently seen the UK banking regulator, the Prudential Regulation Authority (PRA), follow the example set by their European peer and instruct UK banks to cancel their dividends. Banks are better capitalised following the introduction of new regulations after the GFC, so this action is understood to be precautionary rather than by necessity and dividends will likely be restarted when the regulator is satisfied peak danger has passed. This will be of little consolation to income investors, who are reliant on banks for something like 16% of the overall dividends paid by the UK market. The PRA may also request insurers, responsible for another 5% of UK dividend income, to follow suit.
In order to estimate the likely reduction to UK dividend income, we look at these sectors which we believe are particularly vulnerable, and mark their dividend yields back to their long-term averages. We make an extra adjustment to finance, where we have visibility that banks will not be paying their dividends and given lack of clarity regarding insurers, we also reduce payments from them by half. This thinking leads us to believe that the UK market could see a cut to dividend income in 2020 of around 40% from the pre-crisis expectations.
Investors who are reliant on income might consider looking at two UK sectors which we believe are better placed to weather a dividend storm. Healthcare and utilities companies currently yield around 4% and 5.5% respectively, both little changed from their long-term averages as investors conclude demand for their services and products will remain relatively robust in the downturn. Income investors orientated in the UK might also consider looking to other markets around the world where they can find lower pay-out ratios.
Cuts to dividends in the equity market also serve as a reminder of the benefits of diversification in a multi-asset portfolio. While government bonds look expensive on a historic basis, the security of their coupon (and principal) payments is reliable. Furthermore, some alternative assets can provide relatively high income levels, although some caution is necessary as yields on all assets, including property, come under pressure.
Therefore, we encourage engagement with our investment managers to look to manage portfolios to meet clients’ needs, while being realistic that income generation will be challenging in the coming year.
Data sourced from Bloomberg/Refinitiv Datastream/Smith & Williamson Investment Management LLP as at 6/04/20
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.
Smith & Williamson Investment Management LLP is part of the Smith & Williamson group.
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