United Kingdom: Dividend and conquer

It's now clear that the UK is in for a prolonged period of economic weakness. Flat 'growth' in the second quarter of 2008 marked the end of 63 successive quarters of economic expansion while the third quarter saw economic activity unequivocally weaken as UK GDP fell 0.5%.

On the ground, the UK housing market has continued to deteriorate with house prices falling faster than during the housing 'crash' of 1990. Consumer confidence has fallen to its lowest level since the early 1970s and unemployment is increasing. Industrial output has been diminishing, despite the recent weakness of the pound, and business optimism is at its worst level since 1980. The only two 'positives' appear to be that inflation has touched a 16-year high of 5% and is now on the decline, thus enabling the Bank of England to aggressively cut interest rates, while confidence in interbank lending appears to be slowly returning following the UK's bailout plan.

Tighter reins

With a large part of the UK banking system now nationalised, the more stringent regulation we expect will put significant pressure on borrowing multiples. As house prices decline, the savings ratio can also be expected to rise. This though will further dampen UK consumer spending in an economy where household consumption represents more than 60% of GDP.

There's no mistaking that the UK economy faces a very difficult period. It is structurally biased towards services - particularly financial services - which are expected to deliver miserly growth in the coming years. In addition, the UK has benefited greatly from the rise in global capital markets over the last decade meaning that the very real threat of a global recession only adds further pressure.

The accelerating rate of change

Changes in the global financial landscape may have occurred with extraordinary speed in the closing months of 2007, but it would be folly to think that the problems which resulted in these changes will be resolved as quickly.

The erosion of confidence in the financial sector will continue to have profound implications in a number of areas. With governments and central banks broadly united in finding solutions to the financial crisis, confidence should be restored and credit conditions should stabilise. However, such rescue packages will take some time to enact. Until we see evidence of their success, we're unlikely to see markets exhibit a sustained rise while continued redemptions mean that heightened market volatility can only persist.

It is important to recognise that the 'new order', when it comes, will be quite different from the old. As de-leveraging continues, in developed economies at least, a protracted period of 'sub-trend' economic growth seems unavoidable. Indeed, the hidden cost of more expensive credit is the additional strain it exerts on capital spending, consumption and asset prices. How violent these trends prove to be will depend partly on the ability of the less indebted, mostly developing, markets to generate domestic growth during a period when levels of global trade are slowing.

A heavy burden to bear

Concerns about the breadth, depth and duration of slowing global growth and the impact of tighter credit conditions are likely to weigh on the UK market for some time. Corporate earnings, balance sheets, cash flows and pension funds will remain under intense scrutiny. Earnings growth estimates for 2009 and 2010 are still suggesting 10-15% growth for the next two years, but the downside risks to these are significant - earnings falls have averaged 19% during the last five UK bear markets.

Of course, dividends become a far more important part of total returns when capital returns are weak. Consequently, we expect equity investors to seek out dividend income and dividend growth in such an environment. Dividend growth will not only contribute to total returns, but also provide guidance to corporate growth prospects, cash flow and balance sheet strength. In previous down cycles, dividends have proven to be more resilient than earnings, having grown by 3% on average during the last five UK downturns. This is because most company boards are reluctant to cut dividends for fear of the signal it sends to the wider market. As earnings fall, they prefer to continue paying their dividends by raising their pay-out ratios and only rebuilding dividend cover when earnings start to rise again.

Softly, softly…

Seeking dividend income and dividend growth takes careful thought, especially as current estimates for 2009 dividend growth of 6-7% appear wishfully high. We expect dividend growth for the UK over the next 12 months to be below inflation as more companies are forced to cut their dividends. Of course, there are plenty of attractive headline dividend yields around, but it's always uncertain whether very high yielding stocks will actually pay out. Sectors where we believe dividend forecasts are most at risk are consumer exposed areas such as house builders, pubs and some retailers.

Recent research by Citigroup also shows a strong correlation between share price performance and dividend changes during bear markets. During the last five downturns, stocks that provided lower than average dividend growth tended to underperform, while stocks offering higher than average dividend growth tended to outperform.

All of this means that the current divergence in share price performance is here to stay, making good stock selection critical. The winners will be those companies that can deliver lower earnings risks and a greater proportion of their total return as dividend yield and dividend growth.