From an equity investment perspective, the world looked a risky place as we entered 2016 and these risks have already weighed heavily on financial markets in the first few weeks of the year. January’s extreme weakness persisted until the middle of February, before stocks staged a tentative and lopsided recovery.
As has so often been the case recently, flows have proved more important than fundamentals in this rally, with another rotation out of so-called “defensive” parts of the market and into commodity-related stocks.
Accordingly, in the first quarter’s results season, the market has shown a tendency to be remarkably inconsistent in how it responds to positive – and indeed negative – fundamental news. This sort of dislocation can occur in the short term, but fundamentals always reassert themselves over time.
Meanwhile, fears that June’s referendum might lead to the UK leaving the European Union have intensified, causing the pound to weaken sharply. This is not the only risk affecting investor sentiment currently, however. There are plenty more. Among them are worries about the health of the Chinese economy, the ensuing volatility in oil and commodity prices, and concerns about tightening global liquidity following the Federal Reserve’s first interest rate increase in nearly 10 years late in 2015.
Moreover, the recent market volatility represents a growing concern among market participants that policymakers globally are failing to fully understand the nature of today’s economic problems and are therefore prescribing the wrong policy medicine. Policymakers have been behind the curve ever since the financial crisis and investors appear to be increasingly concerned rates cannot go low enough to maintain growth.
All this matters at the macroeconomic level and its impact has been, and will continue to be, felt by all companies to some degree. But some businesses are much more vulnerable to the economic headwinds than others.
“The market has shown a tendency to be remarkably inconsistent in how it responds to positive – and indeed negative – fundamental news”
Last year was one of capital risk, with a significant difference between the best-performing stocks on the UK stockmarket and the worst. This year already appears to be one of dividend risk, with dividend cuts already announced from several high-profile mining companies, banks and industrials. We expect this theme to continue over the coming months as the economic headwinds weigh increasingly on the operational performance of cyclical businesses.
The chart below highlights the extent of dividend risk in European markets presently by measuring the proportion of stocks in industries where dividend cover (the level to which dividends are covered by earnings) has been eroded to now sit in the bottom third of its 10-year range.
A reading of zero suggests the risk to dividends is low (but not zero) because it suggests all industries across Europe have levels of dividend cover near or above their 10-year averages. Stock-specific issues can still cause dividend stress, of course, but at an industry level the risk of dividend cuts appears low when the line is at or near zero, as it was most recently in 2005.
Since 2005, however, this measure of dividend risk has risen from zero to 90 per cent, suggesting the vast majority of European industries now have levels of dividend cover below their 10-year average. Again, this does not mean dividend cuts are inevitable this year or in future years, but it does suggest the prevalence of dividend disappointments will remain high. Income investors will therefore need to tread carefully.
At the individual stock level as well as at the industry level, the extent of dividend risk is not equal. We remain attracted to reliable companies, offering the prospect of sustainable dividend growth at attractive valuations. There are not many of them left but, reassuringly, there are enough to build a diversified portfolio in which we can have high confidence in the prospect of consistent and dependable dividend growth for several years to come.
Neil Woodford is head of investments at Woodford Investment Management