Economic growth continued in the UK during 2015 but towards the end of the year, and in all probability into the beginning of 2016, it has slowed somewhat. However, the number in work continues to break record highs and wages are also growing in real terms, albeit relatively modestly. The outlook for growth for the rest of this year is clouded by a number of issues, and we will comment on these later in this Newsletter, while government debt as a percentage of GDP has disappointingly increased slightly. In the current climate it looks very likely that achieving a budget surplus requires currently unforeseen economic growth, higher taxes, further spending cuts or some combination of all of these.
Also, later in the Newsletter we will offer our views on the economic issues surrounding the EU referendum this summer and on the potential impact of this, as well as of broader issues, on asset allocation and portfolio construction.
Initially we would like to comment on certain outcomes of this year’s Budget:
Individual Savings Accounts
The annual allowance for ISA subscriptions remains at £15,240 in the year 2016/17 while from the 6th April 2017, the allowance rises substantially to £20,000. This increase provides further significant opportunities for investors to enhance tax efficiency in respect of both income and capital gains.
A new form of ISA will be introduced from April 2017 for adults under the age of 40. This is to be called the Lifetime ISA to which individuals will be able to contribute up to £4,000 per annum and receive a 25% bonus from the government. Indeed, the 25% bonus will be earned on savings made up to the age of 50 and funds saved can be used towards a deposit on a first home (subject to it costing less than £450,000).
If savings remain invested, once a person reaches the age of 60, any withdrawals will be tax free and they can be used for any purpose. If savings are withdrawn before age 60 (other than to help with buying a first home) the government bonus element, and any gains made on it, will be forfeit.
The allowances for Junior ISAs and Help To Buy ISAs remain unchanged at £4,080 and £3,400 respectively.
VAT at 20%
The rate remains unchanged for a further period.
The personal allowance for this tax year increases to £11,000 and for the next tax year it rises to £11,500. The higher rate threshold, after which tax payers begin to pay 40%, now increases to £43,000 and from April 2017 it rises to £45,000. The additional rate limit remains fixed and £150,000 for this year at least.
The new personal savings income tax allowance now comes into effect, exempting the first £1,000 of savings interest from income tax for basic rate tax payers and the first £500 for higher rate tax payers. Our understanding is that this relates to all forms of interest producing deposits as well as to investment in fixed interest markets, paying interest rather than dividends.
There is a further income tax change, of particular interest to investors, that has come into effect from 6th April this year, in that dividend tax credit is abolished and replaced with a new dividend allowance of £5,000 per annum. The new rates of tax on dividend income above the allowance will be 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers. This will clearly be of benefit to many in receipt of dividend income but there will be losers among those with larger dividend income, depending also upon the level of income enjoyed from other sources.
There is an ever stronger case for married couples to split investments between them to ensure maximum use of allowances and lower tax rates.
The increase in the income tax allowance and the introduction of new arrangements in respect of interest and dividends, together with the increased ISA allowances, will ensure that fewer people pay any income tax at all. Interestingly, around 30 years ago, the top 1% of earners produced a little over 10% of the total income tax revenue: now that figure has risen to between 25% and 30%. Again over 30 years ago, the top 10% of earners contributed in the order of one third of total income tax revenue: that figure has now risen to nearer 60%. As a percentage of income tax received, by far the majority of those in receipt of potentially taxable income are being asked to contribute significantly less proportionately than they were in the late 1970’s.
It remains the case that the current nil rate band (£325,000) is frozen until April 2021. However, from April 2017, an additional nil rate band will apply where a main residence is passed to a direct descendant.
Capital Gains Tax
For the 2016/2017 tax year, the annual allowance remains at £11,100. However, there are significant reductions in the rates of capital gains tax whereby those rates, when calculated with reference to basic rate income tax falls from 18% to 10% while where it is calculated with reference to higher rate or additional rate tax payers it falls from 28% to 20%. Basic rate taxpayers will already appreciate that there is a link between income tax and capital gains tax rates which needs to be carefully considered in the light of their individual income and capital gain levels. The new significantly lower tax rates do not apply to properties that do not qualify for principal private residence relief, for example buy to lets.
National Savings – Premium Bonds
There is no change to the maximum individual investment of £50,000 which was introduced last June.
After a period of great change around pension legislation, no major further changes have been announced. However, the lifetime allowance is being reduced as planned and while there was some speculation that tax free cash might be in some way curtailed, there was no suggestion of this in the budget.
Legislation is proposed that will enable payment of a “serious ill health lump sum” at any age where an individual has a life expectancy of less than 12 months. This will be tax free for individuals under the age of 75 while for those over 75, it will be taxable at their marginal income tax rate rather than the current 45%. The proposal is that this lump sum can be paid from crystallised funds, i.e. those pensions where the tax free cash has been taken and/or where income is being drawn down: the aim is to provide some assistance to the terminally ill.
The main headline was the reduction in the rate of corporation tax from 20% to 17% by 2020. Larger companies do however face new restrictions on tax deductions of interest costs, potentially offsetting the headline corporation tax reduction but arguably creating a more straight forward and visible system.
Small businesses on the other hand will benefit from April 2017 in respect of an increase in business rate relief.
A whole range of other changes to business taxes were announced, including among them significant changes to oil industry taxation which industry has of course been very hard hit by the collapse in oil prices.
The budget contained far more points of detail than could possibly be covered in this short Newsletter. However, we hope that we have been able to offer you a summary of the opportunities available for investors, particularly in respect of the new income tax allowances for interest and dividends, for the continuing benefits of ISA investment and for the need for careful pension planning – a particularly complex subject requiring advice on an ongoing and an individual basis.
Next year’s change in respect of Inheritance Tax on main residences also provides a new planning opportunity.
The EU Referendum from an Investors standpoint
The economic consequences of a decision by the UK to leave the European Union are unknown. Those campaigning to leave the EU base their economic case on the belief that the UK, if out of the EU, will benefit economically in the long term, notwithstanding short term disruption. There is of course no way in which this can be factually demonstrated and the question that voters have to ask themselves is whether or not the suggested, entirely theoretical and possibly elusive benefits, are large enough to warrant the risks that will have to be taken in order to find the answers.
Long term consequences of remaining within the EU on the other hand will to an extent depend upon the Union’s future economic policies, the development of which will be heavily influenced by a committed UK, which is the Union’s second largest economy, and therefore in a very powerful place to participate. What is certain is that remaining in the EU will avoid substantial and potentially extremely disruptive risks that ‘Brexit’ will without doubt give rise to and which, in our view, have the potential to be very negative in the short and medium term at best.
A key example of unknown economic outcomes relates to trade between the EU and the UK, in terms of both goods and services. In very round figures indeed, the trade in goods between the UK and the EU broadly balances by value. On this basis, one might argue that a UK Brexit would leave both sides with a very broadly equal need to sort out sensible trading agreements. However, and again in round figures, some 40% of the UK’s exports are to Europe while, because the EU is so much larger, less than 10% of the EU’s exports head to the UK. When looked at in proportion to the two economies, the UK is much more dependent on Europe than the other way round. If one then adds financial services into the equation, the City of London is far and away the largest financial centre in Europe and, in the event of Brexit, its seems likely that the remaining EU would be heavily incentivised to build its own financial services, possibly behind protectionist barriers, with obvious adverse consequences for one of the UK’s major areas of economic activity. Brexit would also require full renegotiation of the UK’s trading agreements with the rest of the world, work that may take many years to complete.
It is clear that, from an economic standpoint at least, voters have to make a judgement call on unknown outcomes concerning particularly difficult short and medium term factors, and on their longer term impact, to the extent of which professional economists disagree. From our perspective, as investment advisers we consider that Brexit has the potential to enhance prospects for significant recession in the UK over the next three to five years and this will clearly influence our asset allocation advice.
Equity markets in particular started 2016 in a negative mood but this has changed for the better in recent weeks. As things stand today, markets are anticipating modest increases in US interest rates this year and, subject to one caveat to which we will return shortly, no increase in UK interest rates until at least 2017. In terms of economic growth, the anticipation is that by international standards, there will be substantial growth in China, albeit at slower levels than has been seen for some years as the Chinese economy further rebalances towards consumer expenditure while dealing with a debt overhang. Within the Eurozone, GDP growth is expected to rise, albeit relatively modestly, while again subject to one caveat, growth in the UK will probably continue, and may pick up a little on the 2015 outcome in the view of at least some economists, while growth in the USA will probably also pick up a little further.
Expectations of inflation and deflation are very specific to country or monetary regions. In the US and the UK, low commodity prices and low growth in money supply may continue to hold back inflation while in the EU and Japan, low commodity prices plus a long period of low money supply growth arguably tilt the balance in favour of some deflation. However, in parts of South America for example, inflation is particularly high (in Brazil 10%): here, countries need to increase interest rates to check inflation that the very time that their economies are shrinking in which circumstances interest rates might normally be lowered.
We think it possible that a better balance between supply and demand will be found in commodity markets this year: progress has been painful for companies in mining everything from coal to copper, for those extracting oil right through to milk producers here and in, for example, New Zealand where the dairy industry represents a relatively substantial part of the economy. We note, however, that the price of crude oil has risen by some 50% since its low point: the worst of the deflationary impact of falling oil prices may now be behind us.
Turning now to the outlook for company profits, prospects of at least modest growth globally will provide opportunities for well managed flexible companies to deliver reasonable if not spectacular outcomes. After a year when many of the substantial international commodity producers have been forced to reduce dividend payments, our view is that this sector may start to show greater stability. This matters in particular for investors in the UK market as a significant percentage of FTSE 100 index companies, operating globally, are listed here.
The performance of fixed interest markets for the rest of this year will depend upon how accurate the market’s views on interest rate trends turn out to be. If progress towards higher rates in the US in particular remains slow then fixed interest prices will for the most part remain stable and value will continue to be provided through interest payments. There is however the possibility that rates may rise faster than anticipated and a number of fixed interest fund managers are maintaining a cautious balance within their portfolios accordingly.
All of these influences will of course continue to be with us into 2017 and beyond. Our view is that current asset values reasonably reflect the balance between opportunity and threats and that over the medium term, say three to five years, the opportunity element is currently undervalued, particularly in equity markets. It is for this reason that, as a broad rule of thumb and for longer term investors, we continue to favour equities over fixed interest investment. On the other hand, for those who seek capital preservation in the short term, are rather more cautious approach is called for.
Within equity markets, we see particular value in Europe and Japan while for those for whom an element of greater risk is acceptable within the context of a well-diversified portfolio, emerging markets and commodity investment may prove worthwhile.
The US equity market again offers long term value but over the next 18 months or so there are uncertainties about the pace of interest rate rises and inflation, which factors may cause some shorter term volatility; while the US election result may have an impact on market direction.
The UK market is difficult to assess at present. Broadly, we consider that sound medium term value is offered at current levels which are somewhat below those reached last summer but there will be at least a case to be made for greater selectivity than usual as the year progresses given the EU vote in June. Should the UK leave the European Union, we envisage a period of uncertainty for Sterling, boosting the attractiveness of companies with large overseas earnings which are more likely to be found among FTSE 100 share companies. Medium and smaller size companies tend to be more heavily dependent upon the UK’s internal economy which might well be faced with greater pressures.
Summing up on asset allocation within equity markets, as the year unfolds, there may be circumstances which lead us to advise clients to hold a greater element of their assets in overseas, or overseas leaning, investments.
Restructure at Old Mutual Wealth
For our investors who have an investment portfolio on the Old Mutual Wealth investment platform, we would like to take this opportunity to inform you of the announcement in the press of a structural review of the Old Mutual Group. To briefly explain this, Old Mutual PLC has four business units globally – Old Mutual Emerging Markets, Nedbank, UK Old Mutual Wealth and Old Mutual Asset Management. Following a strategic review of the business, Old Mutual has decided that the long-term interests of the Group’s shareholders will be best served by Old Mutual separating the four businesses from each other. Old Mutual believes this is a positive development for all their customers in all of the markets in which they operate. This will have no impact on the policies and investments you hold with Old Mutual Wealth.