2 dividend shares I’d avoid like the plague!

This writer thinks that these cheap UK dividend shares could deliver disappointing passive income next year. Here’s why investors need to be on guard.

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2023 could be a challenging time for UK stock investors as the global economy rapidly cools. Here are two dividend shares I think could provide disappointing passive income next year.

Lloyds Banking Group

Inflation is tipped to sink in Britain over the next year. This adds another layer of risk to retail banks like Lloyds Banking Group (LSE:LLOY).

Last week Bank of England chief economist Huw Pill said that he expects inflation to fall “quite rapidly” in the second half of 2023. This raises the possibility that interest rates could follow suit, with policy makers potentially being encouraged to cut the benchmark by the tough economic environment.

This would be especially bad for banking stocks like Lloyds. The FTSE 100 firm already faces a prospect of soaring bad loans and disappointing revenues as the British economy enters what could be a protracted recession. A narrowing of the margin between the rates it offers to borrowers and to savers could remove any chances of it making respectable profits.

So despite its all-round cheapness, this is a stock I wouldn’t touch with a bargepole. I don’t care if Lloyds shares trade on a price-to-earnings (P/E) ratio of 6.4 times for 2023 and carry a 6% dividend yield. I’d avoid it even though extra cost-cutting could provide a big boost to its bottom line.

Direct Line Insurance Group

Direct Line Insurance Group (LSE:DLG) also offers attention-grabbing value for money, at least on paper. But the FTSE 250 company is another dividend share I’d be happy to pass on.

Okay, Direct Line trades on a P/E ratio of just 8.5 times for next year. And its dividend yield clocks in at a showstopping 11%.

But I’m not convinced that it could generate the sort of passive income that investors might be expecting. I think earnings (and by extension shareholder payouts) could come under pressure from sustained cost inflation.

You see the business is having to hike premiums to protect margins from rising costs. And this is having a devastating impact upon business. Latest financials showed gross written premiums from its Motor and Home divisions slump 8.9% and 10.1% respectively between July and September.

The prospect of profits stress is a particular worry to me given Direct Line’s weak dividend cover. Next year City analysts expect earnings to leap 48% from 2022 levels. Yet this still leaves predicted dividends covered just 1.1 times by expected earnings. This is well below the benchmark of 2 times and above that provides a wide margin of safety.

There’s a big danger that profits could miss this target, in my opinion. Sure, Direct Line’s excellent brand recognition means it could outperform the broader insurance market next year. But the threat of prolonged cost inflation makes the business a risk too far in my book. I’d rather buy other dividend-paying shares today.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Royston Wild has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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