The income conundrum of 2020

08 Sep 2020

Facing the challenge of dividend cuts

“Prediction is hazardous, especially about the future.” Niels Bohr, Physicist.
The ongoing global pandemic has brought a new layer of unpredictability as to how investors might fare over the next year or two, not only in terms of the capital values of portfolios (which have always been subject to periods of volatility) but also the income that can be earned from them.
For income investors, and those using income stocks as part of a balanced portfolio, the year has brought dramatic changes, and many are, sensibly, considering alternative strategies.

How often do we see falling capital and dividend income at the same time?

In recent years, extremely rarely (if measured by the returns from the UK equity market as a whole).
  • In 2008, when share prices tumbled by a third, dividend payments were maintained.
  • In the deeper cycle of 2001/02, shares prices plunged by more than 40%, but equity dividends declined a mere 2%.
  • In the short-lived crash of 1987, equity dividends rose by around 10%.
  • Even in the crisis of 1973/74, when equity prices fell a massive 70%, dividends increased by a double-digit amount (though not keeping pace with rampant inflation).
It was back in 1930/31 when this combination last occurred, but even then, dividend income from the UK stock market dropped by only about a quarter.

What makes 2020 different?

Clearly, this is not a typical recession, in which commercial activity gradually wanes.
The speed and severity of the lockdown initiated by governments around the world caused massive uncertainty in almost every sector in the economy. Companies faced a sudden cessation of operations with no clear indication as to how long it might last.
Decisions to cut or suspend dividend payments have been driven by three factors:
  1. a need to remain solvent.
  2. an instruction by regulators (in the case of UK banks and insurers) to cancel dividends.
  3. a desire to be seen to “share the pain” from a social and political standpoint, so that directors and shareholders suffer, to some extent, along with employees.

How is the UK faring from a global perspective?

The UK corporate sector entered the spring with less room for manoeuvre than many other countries. The proportion of last year’s profits paid out to investors in the form of dividends was about 70% in the UK, compared with 52% for Europe, 45% for the US, 40% for emerging markets, and just 37% for Japan.
Additionally, the composition of UK dividend payments had become unusually concentrated. Just twelve companies contributed more than half the entire pay-out of the FTSE All-Share Index in 2019.
So, as soon as profitability was threatened (and in a dramatic way unlike previous economic cycles) the logical response was to put dividend payments on hold where necessary.

How will this affect investors in 2020/2021?

Equity share prices have already climbed off their lows of mid-March, as governments and central banks have stepped in with immense levels of support. Income forecasts, however, are not bouncing with them.
So far this year, 445 major UK firms have cancelled, cut, or suspended dividend payments. This includes those typically considered most reliable; Royal Dutch Shell cut its dividend for the first time since World War II, BP for the first time in a decade.
So, it’s not unreasonable to predict that as much as half of the next year’s income from the UK stock market will not be paid (compared with a range of 25% to 40% for other regions). The prognosis for the following twelve months will depend on the speed of the UK’s exit from lockdown and return of economic activity.
Those investors who had adopted a passive exposure to equity investing (through index tracker funds) will feel the full brunt of these income reductions. Active investments can offer a degree of mitigation against such fluctuations.

What solutions are available?

More predictable, but meaningful, income is likely to be the new holy grail for both income-seeking and risk-conscious investors.
Should these groups turn, as they would traditionally, to bonds? Not if they are seeking income, unfortunately, and nor if they believe that higher inflation in due course is an inevitable consequence of the amount of debt being created in the present circumstances.
Fortunately, the investment universe offers a much wider range of choices for investors than just equities and bonds.
Medical and social housing: Whilst many commercial property landlords have made headlines for collecting as little as one-third of the rent due in Q2, the owners of medical and social housing properties have had no such difficulties and, consequently, their share prices have been resilient.
Social infrastructure: Equally, providers of social infrastructure continue to be paid, often by public sector bodies, under long-term contractual arrangements. They are therefore confident of maintaining, or even modestly increasing, dividend payments to their shareholders.
Those who have the time and expertise to seek out these opportunities are being rewarded in both income and capital terms. As in any bespoke service, a proper understanding of clients’ needs for income, capital returns, and risk should enable a sensibly diversified and well-balanced portfolio to meet their requirements.
With investment your capital is at risk