Research by Cazalet Consulting estimates UK dividends are declining in real terms, with negative i...
Research by Cazalet Consulting estimates UK dividends are declining in real terms, with negative implications for the direction of the stock market.
The consultancy's work suggests that, after inflation, the dividend on the FTSE All-Share has fallen 5.8% over five years. The figures, calculated up to 31 December 2002, show the All-Share average dividend is down 1.6% over one year, 2.5% over two, 8.3% over three and 4.6% over four years.
'This might help explain why the market is not going anywhere,' said Ned Cazalet, founder of the group.
Speaking at Investment Week's with-profits conference held in London last week, Cazalet pointed out dividends are under pressure from another source as well.
He said: 'Dividend cover is very low, at 1.5 times, against a long-term norm of 2.2 times. Earnings are subject to pressure and there are economic worries and problems with funding pensions.'
Cazalet remains cautious on equities and suggests while they are cheaper than they have been in the past, they may have room to become cheaper still as the P/E on the UK market is 17 times against a long-term average of 12.
Even if equity markets do produce a strong rally, it is not going to help with-profits providers gain financial strength, according to Cazalet.
His research into life office asset allocation suggests the average fund has cut equity weightings back from 70% in 2000 to 35% as of 2003. At the same time, fixed interest exposure, in particular corporate bonds, has risen from 20% to in excess of 50%.
'Should the market bounce, that will not help with-profits funds move up,' said Cazalet. 'Furthermore, it raises the question of whether FSA projection rates should be lowered. Is it right to have a projection rate for new and existing business of 7%, which comes from the era of rising equities? What should a client's expectation be? If the rates are lowered, this has negative implications for endowment projections.'
The yield on 15-year gilts is down from 12% in 1990 to 4.5% today, while that on the All-Share has fallen from 5.5% to almost 4%.
'People are saying the yields on equities are now much the same as those on gilts so hurray for equities but the switch by life offices has not been from equities to gilts but from equities to corporate bonds,' he said.
Cazalet added even the stated equity allocation could be a misleading indicator. He pointed out the exposure could well be hedged, which would reduce the ability of the life office to take advantage of upside in the asset class.
The move into corporate bonds comes at a time when fixed interest has produced long term outperformance of equities, as a result of the bear market which started in 2000.
He told his audience that one of the biggest problems facing the industry is a mindset established during a period of extraordinarily high returns seen during the last bull market.
Cazalet said very few groups thought markets could fall for more than one year, or two years, or three years. In fact UK equities have produced negative annual returns since 2000.
He added: 'If you build a business on double digit growth from markets, and it doesn't turn up then you are in trouble. A year ago one major life office told me the market was at its low, it was at 5,200.
'In the old days with-profits used to have high bonuses, high payouts, provided plenty of product formats and had plenty of free capital from rising markets. There were a large number of providers in competition so to get new business they were generous in their terms and now they wish they hadn't been.
'Several years later the outlook for with-profits is very different. Bonuses are nil or low, steep MVAs are in place, there are a reduced number of product formats, many providers are exiting new business and some of these legacy funds are toxic.'
In the 20 years investors have become used to equity returns of 12%pa above inflation, according to Cazalet, who believes a figure of 5%pa is more realistic in a low inflation environment.
In 2000 Cazalet Consulting estimates the typical with-profits portfolio lost 1%, returning -7% in 2001 and up to -13% in 2002.
Cazalet said: 'Typically life offices need to make around 8%pa to keep solvency steady. That is to compensate for capital erosion from new business strain and paying bonuses. It explains why, in recent years offices have been putting on big MVRs and not paying out bonuses.'
As a result the consultancy is not expecting bonus prospects to look bright in the immediate future. It is predicting more cuts to come as reversionary bonuses trend downwards and terminal bonuses are sharply cut while MVRs become more prevalent.
Despite this, he pointed out with-profits had not been 'the hole in the head other investments might have been.'
Taking figures to 31 December 2002, on a gross and bid to bid basis, he said with-profits portfolios had outperformed the All Companies and Balanced Managed sectors over one, three and five years.
According to his calculations with-profits is up 31.5% over five years against a return of -5.8% for Balanced Managed and -12.4% for the All Companies sector. However Cazalet stressed the with-profits figure did not include MVRs.
Despite the relatively good portfolio performance of with profits, it is risk management which is the key for with-profits offices according to Cazalet. He said: 'The issue is one of liabilities not fund performance. Equitable Life got itself into trouble because of the former, not the latter.'
Cazalet went on to suggest that too many life offices have been taking undue risk and then using a range of accounting and valuation methods to dress up the balanced sheet.
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