Why Barclays could become an unlikely income ‘champion’

A recent poll suggested people in the UK are more worried about inflation than Brexit. That’s understandable, in my view, since Brexit is an event which will not take place for at least two years. Inflation, on the other hand, is rising now. It is forecast to reach 2.7% this year, according to the Bank of England. Other forecasts have the figure at over 4%. In any case, it looks likely to move past wage growth of 2.6% and could even push past the FTSE 100’s yield of 3.7%.

In such a scenario, I believe high-yield shares will become more popular. I think a lack of inflation-beating yields will cause more investors to turn to riskier, less obvious alternatives. One of those will be Barclays (LON:BARC), in my opinion. Before the financial crisis it was seen as a solid dividend play. While that status may not return, a rapidly rising dividend and low payout ratio could make it more popular as inflation ticks higher.

A sudden threat

Just six months ago, inflation in the UK was only 0.6%. It hasn’t been higher than 2% since November 2013, which has created benign conditions for income investors. Although low interest rates have meant cash balances and bonds have yielded relatively little, dividend shares have left income investors with returns in real terms of 3% or more in the last few years. Therefore, it has been a fairly straightforward existence for dividend investors in the last three or four years.


However, that situation is quickly changing. Inflation has picked up sharply since the referendum and has experienced negative correlation with sterling. This is to be expected, since a weaker pound is making imports more expensive. Although UK exporters have benefited from a depreciating pound, a range of goods and services are creeping up in price due to higher import costs.

The political situation in the UK is very fluid. As I write, Nicola Sturgeon has said she will seek a second independence referendum, which could create greater uncertainty regarding the UK economy over future months. This comes just a few weeks before Article 50 is due to be triggered by Theresa May, which kicks off a negotiation period lasting two years between the UK and EU. During this time, I believe the uncertainty which has pushed the pound south versus a basket of currencies will intensify. Inflation could surprise even the most pessimistic of expectations.

A fast response

Given inflation is likely to move higher, it seems obvious that companies in the top quartile based on yields will become more popular. The problem is that a number of ‘traditional’ income stocks, such as utilities and consumer goods companies, may not offer a positive return in real terms. For example, Unilever yields 2.7%, British American Tobacco yields 3.3%, Severn Trent yields 3.4% and even National Grid now yields 4.4%. All of these yields could be surpassed by inflation and rendered undesirable from an income perspective.

…I feel Barclays could become a more appealing income stock to investors in the latter part of 2017 and into 2018. This could act as a positive catalyst for its share price.

In such a scenario, I believe investors may be willing to consider riskier options in order to obtain a dividend yield which is above inflation. I also feel they will be willing to accept a slightly lower yield in order to obtain the potential for higher dividends further down the line. Therefore, I feel Barclays could become a more appealing income stock to investors in the latter part of 2017 and into 2018. This could act as a positive catalyst for its share price.

A changing business

As mentioned, Barclays was seen as a solid income share prior to the financial crisis. Even after the 2008/09 recession, it continued to pay dividends and was held by some income investors. However, since its current CEO decided to maintain dividends at a relatively low level, few investors have sought it out for its dividend. While I think Barclays made the right decision to prioritise its balance sheet over shareholder payments, its dividend appeal suffered. Now, though, it is forecast to return to much higher dividend payments than in the last year.

For instance, in 2018 its dividend payments are anticipated to rise 153%. This means it has a prospective yield for 2018 of 3.4%, with dividend coverage anticipated at 3.05x. In my view, this indicates rapid dividend growth potential.


Barclays may need to invest further in its business in order to become more efficient to reduce its cost/income ratio from the relatively high 76% last year, while more capital may be required to improve its CET1 ratio from last year’s 12.4%. However, I feel the business may be on the cusp of change regarding dividends. I think this will help it to become more appealing to income investors at a time when they may be seeking new options. Specifically, where dividend growth and the potential for an inflation-beating yield are more likely than for ‘traditional’ income stocks.

Outlook

In my opinion, inflation will become a bigger problem for investors as 2017 progresses and we move into 2018. It is forecast to reach 3% or 4% in the near term, and I think this will pose a problem that income investors have not experienced in the last few years. As a result, I believe they will be willing to look at riskier, more cyclical companies in order to obtain a yield which either beats inflation today, or has a realistic chance of doing so within a matter of a year or two.

I feel Barclays could therefore return to the income fold in 2017/18. Although dividends have been overtaken in importance by investment in the business, a rapid increase in dividends is forecast for next year. As well as this, a low payout ratio indicates further growth potential beyond 2018. Therefore, while definitely not a popular income stock based on today’s 1.3% yield, Barclays could become an income ‘champion’ for dividend investors.