Incoming! A challenging year ahead for UK dividends

2015 was another bumper year for income-oriented investors with companies paying out over £80 billion in ordinary dividends and an additional £5.6 billion in special dividends. 2016 looks unlikely to be plain sailing with income investors facing some difficult decisions and therefore needing to consider less traditional sources of dividends.

Last year, the FTSE All Share constituents delivered dividend growth of 8%. To put that in an historical context, since 1960 real dividends have grown at around 2% per annum. Three key themes have driven this considerable growth.

First, oil & gas and basic materials businesses make up a large percentage of the top dividend payers in the UK and have materially contributed to the growth in dividends. Given the steep fall in commodities prices, it’s not surprising that the earnings and cash generation at these companies have begun to face some strong headwinds.

Yet despite the collapse in commodities prices, businesses in these sectors still delivered substantial increases in their dividends over 2015. This phenomenon leads us to the second source of growth in 2015, the strengthening dollar. Dividend growth contributed by commodity sectors has largely been the result of the strengthening dollar, not increasing payouts. Five of the top ten dividend growers in 2015 were in the resources sector and all were dollar payers. However, the strengthening dollar didn’t just help the resources sector. Other large dividend payers, including HSBC and GSK, also benefited from the currency’s strength.

The concentration risk is troubling though, particularly when you consider BP CEO Bob Dudley’s comments at Davos where he said $10 oil was “not impossible” and BHP Billiton highlighted the average prices obtained for all its commodities had fallen by between 20% and 51% during the last six months compared with the same period in 2014.

Finally, the importance of special dividends to the total payout of the UK market should not be underestimated. Specials in 2015 benefited to the tune of £1.75 billion from Standard Life following the disposal of its Canadian business. The next largest contributor was Next, returning £350 million. The dependence on a few considerable payouts should not be underestimated. Specials accounted for 6.5% of total UK payouts in 2015 and are therefore an important source of income. The good news is that we have had £3.4 billion of specials already announced for 2016.

The unusual drivers of dividend growth last year make it difficult to predict the income outlook for 2016. Time will tell whether the resource companies are able to maintain their dividends, given considerably lower commodity prices and dividend cuts from Glencore, Standard Chartered and Anglo-American already announced. However, continued dollar strength and ongoing special dividends could partially offset these headwinds and there is still a chance that overall income returns will grow this year. This peculiar set of circumstances will make 2016 one of the most challenging for income investors in recent history and may force them to consider less traditional sources of dividends such as FTSE 250 companies.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.