Lofty valuations and crumbling commodities raise doubts over European dividends

* Dividend growth in Europe to slow in 2016

* Further cuts to come from commodities sector

* Expensive defensives also see yields fall

By Alistair Smout

LONDON, Jan 13 (Reuters) - Investors looking to dividends as a shelter from volatile European markets will be challenged this year, with payouts in jeopardy from falling commodity prices and lofty valuations of usually dependable payers.

This could trigger a sea-change in investor behaviour, after billions flooded into dividend exchange-traded funds (ETFs (Shenzhen: 395013.SZ - news) ) in the years following the 2008 financial crisis as investors sought reliable returns in uncertain times.

European dividend growth is set to slow to 5 percent in 2016, according to Markit (NasdaqGS: MRKT - news) , from 10 percent growth last year. Meanwhile dividends in Britain are set to fall 3 percent, after rising 10 percent last year.

The predicted fall in UK dividends is largely due to the London stock market's heavy weighting in oil, gas and mining stocks, whose prices have fallen sharply.

After the likes of Anglo American (LSE: AAL.L - news) suspended dividends last year, other companies are expected to slash payouts in 2016 as commodity prices remain at multi-year lows. Markit said it expects BHP Billiton (NYSE: BBL - news) to halve its dividend.

Imminent dividend cuts undermine the attractive yields that commodity firms currently offer, while companies in more defensive sectors that are seen as reliable dividend payers are trading at much higher valuations.

"It (Other OTC: ITGL - news) 's going to be a tough year ahead for income investors," said Stephen Payne, Enhanced Income Portfolio fund manager at Santander Asset Management.

"A lot of the market yield is concentrated in sectors like resources, where there are challenges for dividends to be maintained. So the overall picture is a tough one."

Money is already leaving dividend funds.

Dividend ETFs experienced their first yearly outflow ever in 2015, Markit said, and that money is still pouring out of them, with $300 million withdrawn in the first week of 2016 alone.

Markit's data shows $1.5 billion flowed out of the ETFs last year, compared to around $45 billion of inflows between 2009 and 2014.

Just a year ago the global oil sector was the second- largest dividend paying industry, splashing out $134.1 billion globally in 2014, according to Henderson Global Investors.

However, a near 75 percent slump in Brent crude prices since mid-2014 has shrunk the market capitalisations of oil companies, putting cashflow under pressure.

Oil majors cut back on spending on new projects in order to protect dividends. But, while the dividend yield in the sector remains attractive, investors are urged to be wary that the new year may well signal a new round of dividend cuts.

UBS (NYSEArca: FBGX - news) highlights that dividend yields in the oil sector are currently at 6.7 percent, but adds that "most investors would likely agree that this is only a signal to potential upside, with most dividends set at too high a payout ratio".

Analysts said some energy stocks still offered relatively safe dividends, with Barclays (LSE: BARC.L - news) tipping Royal Dutch Shell (Xetra: R6C1.DE - news) , but others nevertheless warned that some payouts in the sector were at risk.

"The idea of just heading for the majors doesn't work - you have to pick the right majors. And some of them, at current oil prices, look very stretched," said James Butterfill, Head of Research and Investment Strategy at ETF Securities.

STRETCHED VALUATIONS

Sectors such as pharmaceuticals and consumer staples have been in vogue over the last few years, due to their solid profits and cashflow.

However, their attractive payouts and rising valuations have earned them the nickname "expensive defensives", and some analysts say that now makes it harder to justify holding on to them for their dividend payouts.

"Earlier this year, we did end up taking some money out of the "expensive defensives", as they got stretched, taking yields down a long way," Santander's Payne said.

Towards the end of last year, the STOXX Europe 600 Food and Beverage index, which includes Nestle (VTX: NESN.VX - news) and Danone (Swiss: 487663.SW - news) , was trading at more than 20 times earnings, at highs not seen since 2008. Valuations of household goods stocks , such as Unilever (NYSE: UL - news) and Reckitt Benckiser (Xetra: A0M1W6 - news) , are above their five-year average.

Still, with many dividends at risk this year, particularly in the volatile commodity sector, some analysts say it is worth paying a high price to hold on to these companies. Markit estimates firms in both sectors will increase dividends, some by nearly 10 percent.

"While reliable cash generators are already rated at a substantial premium, and I don't deny that, the fact is that if volatility is increasing, that's who you go for," Jeremy Batstone-Carr, market analyst at Charles Stanley (LSE: CAY.L - news) , said.

"They are expensive, but I don't care - I'd pay up for reliability." (Editing by Nigel Stephenson and Susan Fenton)