The main indices (a benchmark representing the value of a market’s shares or bonds) of UK shares hit an all-time high at the start of 2017. Many private investors might be wondering where to use their ISA allowance of £15,240 before the end of the tax year on 5th April 2017. On the one hand, you would not want to forego the significant tax benefits of the annual ISA. On the other hand, is it prudent to put money in the stock market after the recent surge in share prices?
The rise in UK share prices since the referendum on Brexit is logical. It reflects the fall in the value of sterling or the British pound against overseas currencies. On 23rd June 2016, the exchange rate between the pound and the US dollar was £1 = $1.49.There has since been an appreciation of around 18% in the US dollar to leave the exchange rate at £1 = $1.22. Against the Euro, the fall in the pound has been 12%.
We believe the fall in the pound is beneficial for UK shares because around 70% of the sales of quoted UK companies come from overseas. The value of these overseas sales (and profits) is boosted by the devaluation when translated back into British pounds. In addition, those British companies that export will have their competitiveness improved although this is partly offset by other companies, such as retailers, who will have to pass on, at some stage, the higher cost of imported goods to their customers.
Given the amount of sales and profits earned overseas by UK listed companies, a significant number pay their dividends in overseas currencies (mainly US dollars). These tend to be the larger companies and they account for 45% of total UK dividends paid last year. The value of these dividends paid in overseas currencies from UK listed companies has risen in sterling terms as a result of the fall in the pound. According to the strategy team at Baden Hill Sanlam, a research provider, ordinary dividends for the UK’s FTSE All Share Index rose by 4.2% in 2016 over the previous year. However, without the currency devaluation, total dividends would have fallen by around 1%.
The other key factor that underpins greater confidence in UK dividends is the recovery in the prices of commodities (physical goods such as oil, gold or wheat). Metal prices rose in 2016 with better than expect economic growth in China. Mining companies are likely to restore dividends in 2017 that had been cut in 2016. The oil price benefited both from global growth and also from determination of OPEC to restrict some supply of oil production. BP and Royal Dutch Shell’s dividends are considerably more secure with the oil price at over $50 BBL when compared with below $30 BBL reached in the first quarter of 2016.
Since 1991 I have managed City of London Investment Trust, which is predominantly invested in UK equities and has grown to have assets of £1.36 billion (at 31st December 2016.) While we have large holdings in BP and Royal Dutch Shell, we have less than the average for the UK indices given their sensitivity to the oil price and the risk of having too much in any one stock. This was well illustrated in 2010 when the Macondo oil spill caused BP to stop paying its dividend for a while and led to it having to pay large fines in the US.
City of London’s portfolio is diversified with investments in 117 companies (at 31st December 2016) including those in sectors such as telecommunications, consumer staples, financials and housebuilders. As an investment trust, it has the ability to retain up to 15% of its income in any one year, building a revenue reserve which can be used to support its dividend during difficult years when there are dividend cuts across the market. Though not a guide to the future, this has enabled it to grow its dividend each year for the last 50 years, the longest of any vehicle in the UK.
All in all, the UK equity market is offering a dividend yield of 3.4%* (FTSE All Share Index) which is attractive relative to the main alternatives such as 10 year gilts (or UK government bonds) yielding 1.35%* or bank deposit rates, anchored by the UK base rate at a paltry 0.25% (*source: Financial Times 19th January 2017.) While equities are inevitably more volatile than other asset classes, the income attraction of UK equities is currently considerable. This may give comfort for the patient investor in the context of the many political and economic uncertainties.