Deutsche Bank Bearish on British Pound as Dividend Inflows Forecast to Dry Up

Payments from multi-national companies to U.K investors have been a major driver of higher pound exchange rates over recent years, however this support is forecast to fade warn Deutsche Bank.

As if we needed more negative forecasts concerning sterling.

We have heard all about how the Bank of England and Brexit are playing their part in underming the currency, but now there is another worry on the horizon - a potential drying up of cash inflows from the UK's vast global investment portfolio.

The recent news that BHP Billiton, the anglo-Australian mining, metals and petroleum conglomerate, has slashed its interim dividend payments by 74%, may not just hurt holders of their shares, but also the British pound.

According to a recent study by Deutsche Bank high dividend flows back to UK shareholders have been propping up demand for sterling despite a broader deterioration in the Balance of Payments (the difference between inflows and outflows of money based on trade). 

A steep fall in parts of the Primary Income Balance, a large subcategory of the U.K’s Balance of Payments which governs investments has been targeted as the primary culprit.

These large dividend payouts to shareholders have essentially compensated for a significant shortfall in other inflows, known broadly as Foreign Direct Investment (FDI), and include repatriated operating cash flow, or inbound capital investment:

“Dividend payments remitted back to the UK have been rising at the expense of capital investment and operating cash flow. UK corporate saving decisions have therefore mitigated the economic impact of the decline in FDI profits. In this sense, the exchange rate may have seen an actual flow improvement as the current account deficit widened.”

Deutsche argue, however, that these relatively high dividend payouts are unlikely to last in the long run:

“This is unlikely to be sustainable, however. Indeed, in the last few weeks several large UK based mining companies announce the end of progressive dividend policies. Last night, BHP Billiton joined the list, slashing its mid-year dividend by 74%.”

Given these dividends constitute a surprisingly sizeable slice of the total demand for sterling, a reduction could well have a negative impact on the currency:

“If dividend payouts continue to fall, sterling will start to feel the full brunt of the deterioration in the primary income account for the first time.”

Underlying deterioration in U.K foreign assets

The Deutsche report that high dividend payouts have cloaked a broader deterioration in the Primary Income component of the Balance of Payments since 2011.

The steady leeching has several sources, but one reason is the high number of U.K companies relocating abroad for tax reasons:

“UK companies may have chosen to relocate their headquarters abroad for tax reasons. This would mean that those companies’ operations outside the UK would no longer be counted as UK FDI assets, while operations within the UK would now count as a UK FDI liability.”

Another more significant reason is due to a fall in basic profitability in U.K foreign assets, which have seen yields eroding over time:

“A second reason for the decline in the FDI income is that net profitability on the UK’s foreign assets has fallen. The implied yield on the UK’s FDI assets abroad has dropped from 8% in 2011 to under 6% today (Figure 4). The net yield between UK FDI assets and liabilities has dropped from over 3% to less than 1% over the same period.”

Deutsche argue the reason for the drop in profitability is that outbound FDI had been heavily concentrated in, “the financial services and commodities industries, two sectors that have seen a structural decline in profitability.”

Nor do Deutsche see much let up in those sectors going forward:

“The UK is long banks, miners and telecoms: all are suffering There is a lot of evidence pointing to falling profitability in UK companies. Returns on equity in stocks in the MSCI UK index have fallen from 16% to 11% since the post crisis peak, larger than the fall in the Eurozone.

“Financial services, mining and quarrying, information and communication and petroleum and chemicals make up 73% of FDI assets held abroad.”

The report goes on to explain in more detail why these sectors have been pressured:

“These four sectors have contributed 84% of the decline in UK FDI earnings since 2011. Relatively speaking, earnings in these sectors have been poor compared to earnings in other UK FDI sectors.

“It is well understood that mining and oil companies have faced headwinds from falling commodity prices. Financial services have also faced challenges to profitability from regulation, low interest rates and weak growth. In the case of telecoms, the reason for the decline in profitability is more idiosyncratic, due to weak European revenues and a subsequent sale of a foreign arm of one large UK telecoms company.”

A Preference for Dividends

The fact that these companies have been maintaining high dividend payouts despite seeing their profits falling is both alarming and something of a mystery, but it appears to be the case:

“The fact that UK corporates have been paying out higher dividends on lower profits can be seen in the payout ratios between the UK and Euro Area. The payout ratio has increased for both, but more so in the UK.

“Unsurprisingly, the higher payout ratio seems concentrated in the energy, materials and telecoms sectors, which have been responsible for the overall fall in FDI income. Rather than UK companies keeping profits abroad, therefore, there has been a move towards rewarding investors via remitting profits. UK corporates with subsidiaries abroad have been dissaving.”

The reason why companies have maintained high dividends despite falling profitability are mixed, with one company paying out a higher dividend as a result of a sale of part of its business, however: “There have been other reasons. Last decade, some UK mining companies instated progressive dividend policies, a commitment to pay shareholders at least as much in dividends each as the previous year.” 

Clearly this flies in the face of logic and is unsustainable:

“First, there is a fundamental contradiction between higher dividend payouts and lower profits. Our mining team argues the progressive dividend policy has been unhealthy for mining companies.

“Second, earnings in these industries are not likely to pick up soon. Our equity strategy team believes UK equities are on the cusp of an earnings recession.

“Finally, the fact that UK companies have been paying out larger dividends at the expense of growing their businesses abroad does not bode well for the long run outlook for the current account.”

The report ends with the sobering thought that once companies cut dividends the pound is likely to suffer:

“In the future, these dividends are unlikely to be sustainable, meaning that the exchange rate will start to feel the full brunt of the deterioration in the primary income balance. This reinforces our structurally bearish view on the pound.”

Currency Markets Update: US Dollar Support Growing

We have meanwhile noted a slowing in the pace of selling of the British pound against the dollar.

This even as the US dollar was supported against other major currencies by the strong US durable orders data yesterday.

EUR/USD fell below 1.10, while GBP/USD fell back from highs of 1.3997 but remained above 1.39.

Weak Swiss inflation data also weighed on the franc.

The downward revision to January euro area CPI inflation had little impact on the euro, but focus will be on February inflation data from Germany, France and Spain, ahead of the euro area (and Italian) release on Monday.