Interactive Investor

Fund ideas and areas of concern for income investors in 2023

10th January 2023 11:10

by Danielle Levy from interactive investor

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Danielle Levy highlights the key opportunities and risks for income-seeking investors, as well as sharing some fund ideas.

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In spite of a positive year for dividends, investors could be forgiven for feeling like we are experiencing the quiet before the storm.

This year, the dividend recovery continued as companies raised or reinstated payments following dramatic cuts in 2020, at the height of the pandemic.

In the UK, Link Group is forecasting a 5.5% year-on-year increase in headline dividends to £97.4 billion in 2022, buoyed by strong dividend growth from oil and gas companies, as well as banks. Meanwhile, a stronger dollar benefited blue-chip companies with dollar-denominated earnings, which become even stronger when translated back into sterling. Link estimates that a strong dollar could add an extra £5.7 billion to UK payouts in 2022.

It was a similar story abroad. Janus Henderson Investors expects headline global dividends to increase by 8.3% to $1.6 trillion in 2022, reflecting the exceptional strength of payments from oil companies and large one-off special dividends.

While this makes for positive reading, income investors may well be feeling nervous as they look ahead to 2023. High energy and food bills, coupled with rising interest rates (which have caused mortgage rates to increase), have caused consumers to rein in their spending as they struggle with a higher cost of living. Meanwhile, recessions are forecast in the UK, continental Europe and the US in 2023.

These factors are likely to put company earnings under pressure, which could mean there is little dividend growth next year or, worse still, cuts.

“Dividends are absolutely under threat,” said Andrew Wilson, chief investment officer at Lockhart Capital Management.

He cautions: “The economic environment in the UK is clearly unattractive, and many other countries face similar issues. Global growth will be anaemic in 2023 and there are very few sectors that will be able to avoid the slowdown.”

More than ever, Wilson says it is incumbent on fund managers to identify niche and unique businesses that are able to navigate a challenging economic environment.

For those looking for potential equity income funds to invest in, he says it is important to consider whether their dividends look sustainable in a recessionary environment. While high yields may seem attractive, they may be at risk of being cut, while those offering moderate payouts could have more of a chance of being maintained.

Surviving the pandemic

The economic backdrop certainly looks difficult, with the UK and Europe already experiencing falls in GDP. Kelly Prior, who forms part of the multi-manager team at Columbia Threadneedle Investments, acknowledges that income investors have “muscle memory” from recent market shocks (not least the pandemic), but says there are still reasons to feel upbeat about 2023.

“History would suggest the ‘dividend rug-pull’ is merely moments away, but this time things may well be different,” she explained.

Prior points out that dividends look much more sustainable following the pandemic because company management teams have sought to preserve cash. Therefore, balance sheets have strengthened as a result.

Dan Cartridge, an assistant fund manager at Hawksmoor Investment Management, agreed: “The reset of dividends in the UK market in 2020 means that the dividend base is far more secure today than it was pre-pandemic.

“Dividend cover for the whole UK market is much higher, while payout ratios (which measure how much of a company’s earnings are paid to shareholders) are lower. As a result, even if it is a more challenging year from an earnings perspective, the likelihood of broad-based dividend cuts is low.”

While 2023 in unlikely to see a repeat of some of the special dividends that were paid, particularly from energy companies, he thinks core dividends should remain robust.

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Top UK equity income picks

In the UK, Cartridge favours multi-cap income funds that are not reliant on large energy companies or banks to generate most of their income. These include the LF Gresham House UK Multi Cap Income and FP Octopus UK Multi Cap Income funds.

Both funds favour small and medium-sized companies, two parts of the stock market that struggled in 2022 because the fortunes of these businesses tend to be closely tied to the health of the British economy. These companies were impacted by the weak pound, political instability following the resignations of prime ministers Boris Johnson and Liz Truss, high inflation and the prospect of an economic slump that could last for two years (if the Bank of England is to be believed).

However, Cartridge believes there is potential for a small and mid-cap recovery in 2023 and notes that the underlying stocks in the Gresham House and Octopus portfolios look cheap.

Prior highlights Montanaro UK Income, another fund that favours small and medium-sized companies with attractive growth prospects. “With some small-caps looking very cheap in comparison to large-caps, we believe it is a fund worth owning – even in a more difficult economic environment,” she said.

Unlike Cartridge, she is happy to own a fund with a sizeable allocation to energy companies and banks, and highlights TM Redwheel UK Equity Income as one to watch. It focuses on undervalued businesses, which led the managers to invest in energy companies and banks, which they believe are now in much better health compared to previous market shocks, like the pandemic and financial crisis.

In the multi-manager CT MM Navigator Distribution fund, Prior and her team currently favour UK equity income funds over their international peers on account of the higher dividends and cheaper valuations on offer.

“We believe the UK equity income sector will likely be more resilient than international peers in this environment,” she said.

“It is well-documented that the UK market is more ‘cyclical’ in nature. Going into a downturn, you might expect the UK market to underperform. However, high energy and resource prices are the cause of this marketdownturn,not a symptom of it.

“We would expect companies in the energy sector, which forms a relatively large part of the UK market,to continue to make excess profits and distribute these to shareholders.”

UK equity income funds typically offer higher dividend yields than their international rivals because the UK market is dominated by mature companies in the tobacco, oil and financial sectors, which tend to pay attractive dividends.

“It is also partly to do with how companies return cash to shareholders. In markets like the US, more emphasis has been given to share buybacks over dividends,” Cartridge said.

“Though it is worth noting that over the past 12 months, given the lowly valuations of many UK companies, share buybacks have been running at high levels across the UK market.”

In interactive investor’s Super 60 investments list, income options include the multi-cap focused Diverse Income Trust (LSE:DIVI), managed by Gervais Williams. It is yielding 4.5%. For investors looking for larger company exposure, this is provided by City of London (LSE:CTY) investment trust. It has a yield of over 5%, and is a “dividend hero”, having grown its income for 56 consecutive years.

The direction of the dollar

A stronger dollar affected the returns of both UK and global equity income funds this year. It appreciated against most major currencies for a large part of 2022. This benefited investors with exposure to UK and international companies with dollar-denominated earnings.

However, since November this trend has started to reverse. Will the dollar continue to weaken in 2023?

“Investorswill have everything crossed that the dollar weakens next year, as few markets and asset classes benefit from a strong greenback,” said Wilson.

He adds: “A weaker dollar should allow for other international markets (not just the US) to outperform, as well as commodities, and certain bond markets.”

Wilson notes that the timing of the peak in the dollar will be connected to monetary tightening in the US, and whether interest rates there stay higher for longer, or whether Federal Reserve chair Jerome Powell ends up loosening policy.

If the dollar continues to weaken against sterling, it could have negative repercussions for UK companies with dollar earnings, namely the same companies that profited in 2022. This in turn could affect dividends, as well as special dividends.

International prospects

Outside the UK, where are professional investors seeing income opportunities?

As payout ratios tend to be lower in Asia, Cartridge doesn’t expect to see dividends coming under pressure in this region, even if economic conditions prove challenging.

“On a global basis, we are currently finding exceptional opportunities in Asian equity income portfolios,” he added.

Here, he highlights Prusik Asian Equity Income as one to consider, with an attractive dividend yield of around 4.5%.

Meanwhile, two global income strategies stand out for Dzmitry Lipski, head of funds research at interactive investor. First, he highlights Murray International (LSE:MYI), where manager Bruce Stout of abrdn has invested close to half the portfolio in companies based in Asia-Pacific (excluding Japan), Latin America and other emerging markets, where he is finding the best opportunities. The investment trust currently yields 4.2%.

His second pick is the Baillie Gifford Responsible Global Equity Income fund. Its managers James Dow and Toby Ross exclude stocks in certain industries such as tobacco and alcohol and follow the principles of the UN Global Compact. This covers areas such as human rights, labour, the environment and anti-corruption.

“The fund is a compelling choice for those seeking a high and rising income from responsible equity investments. It currently yields over 2%,” Lipski added.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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