UK: Financial & Tax Planning - Investment Outlook, Summer 2007

Last Updated: 5 September 2007

In this issue

  • Pension options explained
  • Using IHT exemptions
  • Protecting pension benefits on death
  • Nil-rate band discretionary will trusts
  • ‘Non-working’ spouses in a family business
  • Transferring a pension overseas
  • Buying a property overseas
  • Alternatively Secured Pensions
  • University fees planning
  • Investing in gold
  • Investment outlook

The Daunting World Of Pensions What Are Your Options?

We provide a guide to the world of personal pensions, including ASPs and protecting benefits on death. Elsewhere we tackle transferring pensions and buying property overseas. Plus IHT and university fees planning and thoughts on gold investment.


The world of retirement planning can be overwhelming. To help you make your decision, we explore three individual contracts and their differences.

Although the rules governing how much individuals can contribute to, and accumulate within, UK-based pensions were harmonised on 6 April 2006, vast differences in investment flexibility and charging structures remain.

In this article, we investigate the key differences between the three individual pension contracts available: stakeholder, personal and self-invested.

Stakeholder Pensions

The primary difference between a stakeholder and a personal pension is that the former must, by law, meet certain standards in respect of, amongst other things, access and charges. These standards aim to make stakeholder pensions accessible to those with low or zero earnings, and to make charges more transparent.

Stakeholder pensions must accept contributions from £20, which members can cease at any point without penalty. There are no upfront charges or transfer or early retirement penalties. The annual management charge (AMC) is capped at 1.5% for the first ten years and 1.0% thereafter, and is the only permitted charge. The AMC must cover all administration and investment management costs, as well as adviser remuneration.

Limited Investment Options

Although a stakeholder pension is generally the cheapest option for those without access to an employer-subsidised scheme, the restriction on charges means that such contracts are also the least flexible in terms of investment options offered.

Stakeholder pension providers are required to offer a ‘lifestyling’ fund, which automatically switches investors out of equities and into fixed-interest securities and cash, as a default investment option when they near retirement. Some contracts, notably those available from banks and building societies, offer no other alternative.

Some pension providers give access to a handful of alternative funds, which are usually managed in-house; some also provide limited access to externally managed and tracker funds. But most managers do not provide a particularly wide range of funds, which is understandable given such a restrictive charging structure.

We believe that this lack of investment flexibility means that, in spite of low charges, stakeholder pensions are generally only suitable for smaller contributions or those with little desire to invest outside the norm.

Personal Pension Plans

Personal pension plans (PPPs) were the original individual personal pensions and replaced retirement annuities on 1 July 1998. PPPs have similar legal structures to stakeholder plans, however, they are not restricted by the same charging regime and can offer a much wider range of funds.

Modern PPPs offer between 50 and 100 funds covering most asset classes, sectors and geographical regions. Although some are managed internally, many are provided by external investment houses. This enables investors to move between funds and fund management groups as their circumstances and market conditions change.

Some funds will charge an AMC of more than 1.5%, although a reduction in this charge is often offered by way of ‘large fund rebates’. Investors will have to consider whether the availability of a wider range of funds, together with access to a number of fund management groups, justifies a possible increase in costs.

Self-Invested Personal Pensions

Self-invested personal pensions (SIPPs) are a form of PPP which give individuals far greater control over their investments. As a result, their popularity has grown since the pension contribution rules were relaxed on 6 April 2006.

SIPPs are currently available from SIPP providers approved by the Financial Services Authority, and come in two basic forms: the ‘hybrid’ and ‘pure’ SIPP.

Hybrid SIPPs

Hybrid (or deferred) SIPPs are generally offered by insurance companies and require investors to place a proportion of their funds into the provider’s funds. There are variations to this theme, notably, where providers offer SIPPs better terms for their funds than they do for other investments.

Pure SIPPs

Pure SIPPs allow access to most investments, notably, equities, futures and options, fixed-interest securities, cash deposits and commercial property. SIPP regulations prohibit certain investments, in particular, residential property and tangible moveable property, by imposing significant tax penalties.

SIPP members can either manage their funds personally or employ a professional fund manager to do so on a discretionary or advisory basis. SIPPs enable investment that is bespoke to the investor’s circumstances, attitude to investment risk and retirement plans.

SIPP wrappers will have an initial establishment charge, an annual fee and transaction fees which vary with the investment type. An investment manager will levy annual charges and investors will also have to pay for advice and administration.

While SIPP charges are undoubtedly prohibitive for smaller contributions and funds, the investment flexibility they offer could benefit investors with larger contributions or funds compared to the stakeholder and personal pension models. As ever, obtaining expert advice is imperative.


There are many ways for families to reduce their IHT liability. We review the exemptions available.

With tax currently charged at 40% on estates worth more than £300,000, the recent rise in property values has brought even those with relatively modest homes into the inheritance tax (IHT) net. Last year, the Government earned over £3.5bn from IHT, an increase of almost 50% in just five years.

So how can families reduce their liability?

Make Gifts

Certain gifts will fall out of an estate immediately, while others will remain chargeable for up to seven years. The main exemptions are summarised in Figure 1.

Keep Life Insurance Proceeds Out Of The Estate

Life insurance policies should always be held in trust so that death benefits fall outside the estate and can be accessed without probate.

Review Wills

All adults should have a will, which should be reviewed regularly, particularly as children grow older. It should also be noted that marriage or divorce voids previous wills.

Beneficiaries can change a will by mutual consent up to two years after death, which is a useful planning tool.

Equalise Estates

Spouses should make sure that they each own sufficient assets to use their respective nil-rate bands on death if they are transferring funds to others.

Include A Nil-Rate Band Discretionary Trust In Wills

A nil-rate band discretionary will trust allows spouses to settle assets up to the nil-rate band, giving the survivor access to the assets without them falling into their estate. This potentially saves £120,000 in IHT, although the trust must be carefully managed to secure the IHT saving.

Equity Release

Elderly people may have considerable value tied up in their home and many are turning to equity release schemes as a way of unlocking funds which, in turn, can be gifted.

There are two main types of equity release. The first is a lifetime mortgage, which is secured against the value of the home and can be released as a lump sum or regular income. The second is a reversion scheme, whereby a proportion of the property is sold to an investment company, but the seller can stay in the property rentfree as long as they wish.

Such schemes need to be looked at carefully and may only be suitable in certain limited circumstances. But they can be useful planning tools.

AIM Shares And Portfolios

Shares listed on AIM are ‘unquoted’ for IHT purposes, which means that shares held in AIM trading companies are not liable to IHT once they have been held for two years. Life insurance is available to cover the interim two-year period. AIM portfolios that include a broad range of shares to reduce risk are becoming a popular way of tackling IHT.

Discounted Gift Schemes

Discounted gift schemes immediately reduce the value of an estate and further savings can be made if the individual survives for seven years. Such schemes can be used up to the age of 90.

Specific IHT-Saving Schemes

One IHT-saving scheme on the market effectively allows people to swap their home for units in a life insurance fund, which can be gifted while they remain in the property. These are quite flexible schemes, but expert advice is recommended.

Agricultural And Business Property

Assets, such as an office or working farm (including perhaps a farmhouse), may fall outside the IHT net once they have been owned for two years.

Works Of Art And Heritage Property

Pre-eminent works of art and heritage property may be exempt from IHT if members of the public are allowed to view them. Furthermore, some assets can be used to settle IHT liabilities.

Other Gifts

Finally, gifts to registered charities can be made free of IHT and, interestingly, so can gifts to political parties.

Fig 1: A Summary Of The Main Gifts Exempt From IHT

Gifts exempt from IHT


IHT Saving


Annual gift



An individual can give away £3,000 annually or £6,000 if no gift was made the previous year.

Small gifts – an unlimited number

£250 to each donee

Saves £100 per gift

Unlimited gifts of £250 a year to different people, which must not form part of a larger gift.

Wedding gifts (including civil partnerships)



From parent to child.



To grandchildren or great grandchildren.



To anyone else getting married.

Gifts to spouses (including civil partners)


40% of gift

There is a limit of £55,000 on the IHT-free gift when that gift is from a domiciled to a non-domiciled spouse.

Regular gifts from income


40% of gift

Gifts must be from surplus income, be habitual and should be documented.

Lifetime gifts to individuals (potentially exempt transfer)


40% of gift after seven years

As the donor must survive for seven years after the gift is made, it is important to record the date of the gift.


For many people, pension funds represent their second most valuable asset after their home. However, most have little idea what will happen to their pension on their death and very few know how to plan for this eventuality.

Pension funds are usually held either in a pension trust or under the terms of a deed giving pension scheme administrators specific powers to distribute death benefits at their discretion.

On the death of a member, the trustees or administrators will apply their powers with extreme care, taking into account the wishes of the deceased member and his or her family circumstances.

During their lifetime, members can do one of the following with their death benefits to try to ensure that they end up in the right place.

Do Nothing

Pension scheme trustees have a two-year window during which they can pay out death benefits without there being an inheritance tax (IHT) charge. Furthermore, there is no income tax to pay on income arising from the pension fund during this period.

Death benefits will generally be transferred to the deceased’s estate where they will be dealt with under the terms of the will. In many cases, pension funds are left to the surviving spouse, so there are no IHT implications. However, if there is no surviving spouse, the funds could become liable to IHT at 40%.

In some circumstances, and while an individual may not have expressed such wishes, pension scheme trustees may transfer funds directly to the surviving spouse – rather than passing them to the estate – if they are of the view that he or she needs them. They might also listen to representations made by executors, although this cannot be guaranteed.

Nominate A Beneficiary

In many cases, individuals will nominate their spouse to receive the benefits. This has the same IHT impact as passing the assets via the estate under the spousal exemption. However, some people use the nomination to pass pension funds to the next generation, thus avoiding IHT.

On the death of a member, pension scheme trustees will take the nomination into account, but they are not legally obliged to follow it. Furthermore, and before making any distribution, they will ensure that the surviving spouse is financially secure.

Transferring To Trusts Under A Nomination

In some circumstances, individuals may nominate a trust to receive death benefits. In such cases, the same principles mentioned earlier apply and, assuming the trustees follow the nomination, funds passed to the nominated trust will immediately become liable to periodic and exit IHT charges.

Settling Pension Benefits On A Second Trust

Settling pension benefits on a second trust is the most secure way of ensuring that death benefits under a pension scheme flow through to their intended beneficiaries. Individuals settle their pension plans on trust during their lifetime. The pension itself is held for the benefit of the member, as are any other benefits, while the death benefits are held for the beneficiaries of the trust.

On death, trustees must pay the death benefits into the trust from where they can be distributed in the most tax-efficient manner. IHT will not apply to any transfers from the new trust provided they are made within two years of death.


While the issues might be quite complex, the solutions are generally quite simple. The trust route usually offers the most flexibility, and instructing a solicitor to draft a trust should be straightforward.

Doing nothing might not have serious consequences, but circumstances do change and it is important to keep these matters under review.


A recent tax case has highlighted the need to review wills regularly and to ensure that they continue to provide what is intended.

As mentioned in the earlier article on IHT planning, it is recommended practice that married couples and civil partners use both of their IHT nil-rate bands. This may include a provision in both wills to create nil-rate band discretionary trusts, which include the surviving spouse as a beneficiary, helping to allay fears over future financial security.

The arrangement works very well if there are surplus assets, but more and more couples are being brought into the IHT net because of the increasing value of the matrimonial home. In such cases, the practice is for the trust to be established by means of the surviving spouse succeeding to the property in exchange for a debt or by charging the property to the trustees.

The Phizackerley Case

A recent tax case, Phizackerley v HMRC, focused on an anti-avoidance rule which stops debts in an estate being deducted when calculating the amount subject to IHT to the extent that they are derived from property which in turn came from the estate. For example, a father gives £100,000 to his daughter, who then lends him £100,000. On the father’s death, the debt of £100,000 would not be allowed as a deduction from the value of his estate.

In the Phizackerley case, the matrimonial home had been bought in joint names, but the purchase was funded entirely by Dr Phizackerley. On his wife’s death, the executors passed her interest in their home to Dr Phizackerley in return for his promise to pay the trustees of the discretionary will trust an amount equal to the value of her half share in the property plus indexation. On his death, his executors claimed a deduction for this debt.

HMRC successfully argued that the debt derived from the gift made to his wife of the half share in the property and was therefore not allowed as a deduction from his estate.

This argument only applies where the ‘poorer’ recipient spouse dies first. A way round the problem would be for the trustees to hold a charge over the property.

What Now?

While this decision does not stop the use of discretionary will trust, it highlights the need for great care to review wills regularly and to ensure they have not been superseded by changes in the law or its interpretation.


The latest on the Arctic Systems case, a landmark tax-avoidance case for family businesses and ‘non-working’ spouses.

Four years have passed since HM Revenue & Customs (HMRC) first started to take an interest in small family businesses, arguing that income passing to ‘non-working’ spouses should be taxed as though it belonged to the ‘working’ spouse. This was based on legislation originally introduced in 1936.

The Case

HMRC chose to take the Arctic Systems case (Jones v Garnett) to court on the basis that it had all the hallmarks of what they considered to be tax avoidance.

Mr and Mrs Jones formed Arctic Systems Limited to supply Mr Jones’ computer expertise to customers. Both acquired one share at the outset for £1 each. They both earned modest salaries and the profits were paid out equally in the form of dividends, thereby saving income tax and National Insurance Contributions (NICs).

The Argument

HMRC argued that as Mr Jones worked for less than a market-rate salary, thereby allowing the company to pay dividends, there was a ‘settlement’ made to Mrs Jones that worked in Mr Jones’ financial interest. It was this settlement that was caught by the anti-avoidance legislation.

While there was a ‘let-out’ clause for outright gifts from one spouse to the other of property that was not wholly or substantially a right to income, HMRC argued that there had been no gift as Mr and Mrs Jones had both paid par value for the shares.

The Decision

The case has now been decided in the House of Lords in favour of Mr and Mrs Jones. It was agreed that setting up the company with the intention of Mr Jones taking less than a market salary so that dividends could be paid equally was indeed an arrangement covered by the legislation. However, the Lords took the view that the let-out clause did apply.

The Lords’ reasoning was that if setting up the company in those circumstances was an arrangement intended to put dividends into Mrs Jones’ hands, then the value of her share at outset was more than £1 and so there had been a gift. Moreover, they decided that an ordinary share is more than just a right to income, and so that condition was also satisfied.

The Upshot

This was a resounding defeat for HMRC, which immediately retaliated by announcing its intention to change the law so that "individuals involved in these arrangements should pay tax on what is, in substance, their own income". HMRC has confirmed that in the meantime, it will apply the law in accordance with the ruling, removing the threat of back tax claims for many businesses.


In the first of a series of articles on international pension planning, we look at new, less restrictive rules for transferring pensions overseas.

Following the introduction of pensions simplification on 6 April 2006, radical changes were made to the rules governing transfers from UK-registered schemes to offshore pension schemes.

Very simply, individuals who migrate from the UK are able to transfer their UK pension funds to an overseas pension scheme, provided it is a qualified registered overseas pension scheme (QROPS) listed on the HMRC website.

A transfer can also be made in anticipation of leaving the UK, as long as there is an intention to do so within the next ten years.

There are no other formalities other than the UK pension provider satisfying itself that the transferee pension scheme is on the approved list of QROPS and that the individual is a member. Furthermore, providers must notify HMRC that the transfer has been made if the individual is resident in the UK at the time or was resident in one of the previous five tax years. The QROPS then undertakes to HMRC to comply with a number of procedures.

Notably, they are obliged to report future payments made to individuals who are either resident in the UK in the year of payment or who were resident in one of the previous five tax years. This enables HMRC to establish whether the QROPS has made a payment which, had it been made from a UK scheme, would have been an unauthorised payment.

If HMRC decides that the payment is unauthorised, it will raise an assessment on the member of the QROPS. The member will then be responsible for settling this tax liability and, if he or she is resident overseas, this will be policed with the help of the tax authorities in the overseas jurisdiction. Consequently, QROPS can only be established in those countries with which the UK has a double taxation agreement.

Advantages Of The New Rules

The new rules governing transferring pensions overseas will give some migrating individuals significant advantages. Some jurisdictions do not give tax relief on pension contributions while others allow a lump sum pension payment to be made free of all local taxes. It might be possible to avoid tax on a pension fund, subject to the payment being made outside of the QROPS reporting window referred to above.

Potential Traps

However, there are traps for the unwary, particularly where tax rules governing pensions in the overseas jurisdiction are more onerous.

For example, what may have been tax-free cash in the UK could be converted into a taxable pension overseas. This has to be weighed up against any tax liability there might be in the overseas jurisdiction on the same tax-free cash, had it come from the UK scheme.

It is very important to check the double taxation treaty between the UK and the overseas jurisdiction to ensure there are no unpleasant surprises.

Finally, it should be stressed that tax considerations are one of a number of points that need to be looked at carefully when considering a transfer out of any UK pension scheme. You must also assess whether the transfer represents good value, particularly where it comes from a defined benefits scheme.


All in all, the new international pension planning rules are much less restrictive, particularly as transfers can now be made in anticipation of a move overseas.

In the next edition of Financial & Tax Planning, we will look at tax relief on contributions into international pension schemes by individuals resident in the UK.


In our last newsletter, we looked at a potential tax trap when buying overseas property through a company. Now there’s further legislative news that could affect property holding companies.

Many people in the UK have acquired offshore property by purchasing shares in a company or similar vehicle, which, in turn, owns the property.

Unfortunately, this type of arrangement created a potential UK tax charge on the basis that the individual was acting as a director or shadow director, and the company was making the property available to the individual by virtue of his or her ‘employment’.

To rectify this, legislation will be introduced in the 2008 Finance Bill which will disapply the benefit-in-kind charge retrospectively if all the following conditions are met.

  • The share capital (or equivalent) is owned by the director or by the director and other individuals.
  • The company has been the "holding company of the property" since it was acquired. The company must own an interest in the property, which is its only or main asset, and its activities must be incidental to this.
  • The company did not acquire the property, directly or indirectly, from a connected company at an undervalue.
  • No expenditure has been incurred by a connected company.
  • The property holding company has not borrowed funds from a connected company, but if it did, they were immediately repaid.
  • There is no arrangement in place to avoid tax or NICs.

Problems Remain

The planned legislation does not solve the problem for everyone. It clearly refers to cases where the share capital is owned only by individuals. So it appears that it may not apply where the shares are held by a local management company or family trust.

In certain countries, it is reasonably common for the property holding company to be the subsidiary of another shell company. It appears that this arrangement may not be exempt either.

Nor will the legislation apply where the company carries on a trade, or where it is financed by another company connected to the director.

Finally, the announcement only applies to properties outside the UK. Therefore we are still left with a major problem where individuals acquire property through a company in the UK, which is not uncommon for wealthy individuals locating to the UK.

Where an individual is resident in the UK for tax purposes, and occupies UK property owned by a company of which they are a director or shadow director, they may be liable to UK income tax and will need to seek professional advice.


Since their introduction on A-Day in 2006, the rules for ASPs have changed significantly. It may now be time to review the situation.

Alternatively Secured Pensions (ASPs) were introduced in April 2006 as an alternative to buying an annuity at age 75. Since then the rules have changed substantially, and there is now a requirement to take a minimum level of income.

How The Rules Have Changed

The most significant changes cover what happens to the residual fund on the death of a member.

  • If there is a financial dependant at the time of the member’s death, the fund must be used to provide income.
  • If there is no dependant, the residual fund can be paid to charities nominated by the member.
  • Any other payment will be treated as unauthorised and give rise to tax charges of 82%, which means many pension providers will only allow payment to charity.

How The Changes Affect ASP Members

Despite the changes, there are still a number of planning options.

Firstly, members can exhaust the pension fund as soon as they can. Alternatively, and if the pension is not needed, it can be gifted as a normal gift out of income or invested in assets that attract IHT reliefs (see article on IHT planning earlier in this newsletter).

Furthermore, while income may be subject to 40% tax, the recipient may use it to fund pension contributions that would attract tax relief of a similar amount.

Assessing ASPs

The changes to ASP rules make assessing their appropriateness more tricky, although they may still have the following advantages over annuities.

  • Income can be varied subject to lower and upper limits.
  • The decision about what type of annuity to buy is not irrevocable.
  • A higher income can be achieved than from an annuity.
  • Participation in investment markets can continue.
  • In many cases, the remaining fund, as opposed to a proportion of an annuity, can be passed on to benefit dependants.

However, there may also be disadvantages that might impact on whether an ASP is appropriate for a particular individual. For example, an ASP involves a continuing investment risk, with the result that income may go down as well as up. Needless, to say careful consideration of the options is always recommended.


Planning for the cost of school or university education is harder than ever for many parents. We outline some financial strategies to help cope with the rising costs.

A recent survey in The Times has shown that, for the first time, annual private day school fees have reached £20,000 in some cases. In fact, school fees inflation has been running at higher than 10% for a number of years now. This has led to the withdrawal of many insurance-based school fees funding plans, which now require unrealistic growth rates over relatively short periods of time.

A further issue facing parents whose children go on to further education is student loans.

Rising Costs

Maximum university fees for the academic year 2007/8 are £3,070, excluding living costs. Assuming 3% inflation, this will be around £4,125 in ten years.

Some leading universities believe these fees are nowhere near sufficient to cover their costs and fees have the potential to escalate at a similar rate to private schools. So, assuming an increase of 10% per annum, we could see annual fees of nearly £8,000 in ten years’ time. Add living expenses and books, as well as inflation of 3%, and the annual cost for a single student could rise to £12,000 a year.

Providing For The Future

For those currently not paying for private schools, the increasing cost of university education will present a significant financial burden at a time when parents might have expected their expenses to reduce. Yet, if children are still relatively young, there is still time to make provision for some or all of this cost.

This does not necessarily have to involve a specific plan which may tie up funds. To begin with, ISA allowances and other tax-favoured investment vehicles can be used to provide capital growth, with potential for income in future years. Beyond this, planning for the cost of school or university education will require some careful thought.


We examine the attractions of gold investment in the prevailing economic climate.

There are many reasons to invest in gold right now, the most compelling of which are continued US dollar weakness and increasing inflation, against which gold provides a good hedge.

Commentators believe that the US dollar will see continued weakness due to its twin deficits. We expect the US to stealthily devalue the dollar to get these deficits under control, rather than resorting to an immediate devaluation which would be detrimental to world markets.

Diversifying Reserves

Another key driver is diversification of foreign currency reserves on the part of Asian central banks, particularly China’s. Past announcements by the central banks of Russia, South Africa, Qatar and Argentina regarding their intention to add gold to their foreign exchange reserves has caused a shift in market perceptions of the central banks’ attitude towards holding gold.

In China, Monetary Committee members are calling for the country to diversify its $1trn reserves to protect against a falling US dollar. Chinese central bank governor Zhou Xiaochuan was quoted as saying: "China has a clear plan to diversify its foreign exchange reserves and is considering various options to do so." Even a small increase in China’s percentage of gold reserves would cause a huge increase in gold demand.

Gold is a well-known hedging instrument against inflation. In the US, inflation is creeping back in and we are seeing increases in the cost of many items including energy, materials, housing, labour and food. While the consumer goods sector is not yet showing troubling signs of inflation, we foresee a knock-on effect from other sectors, which will ultimately lead to higher inflation.

As Good As Gold?

Having said this, gold can be a volatile investment and is best suited as part of a diversified portfolio. Factors that can impact on the potential investment performance of gold are demand from investors and limitations on central banks due to the transport and storage costs associated with holding gold bullion, as well as the interest sacrificed.

In addition, gold, like other commodities, has seen a strong five-year run and may be due for a correction.

Smith & Williamson¹s Global Gold and Resources Fund is AAA Citywire rated and is one of the leaders in its sector. If you would like to explore investment opportunities into this or any of our other funds we would be delighted to help.


We analyse the recent world market turbulence, and examine investor behaviour across markets in the US, UK, Europe and the Far East.

World Markets – True Confessions

Over the past two months, global investors have been increasingly impacted by the problems of the US sub-prime market. As the prices of tranches of sub-prime debt have plummeted, often accompanied by downgrades from rating agencies, there has been a rush by financial institutions to limit the damage. In other words, they have been forced by the market to divulge their exposure – the alternative being a run on their funds or shares by investors inclined to fear the worst.

Fund redemptions have been frozen to prevent disorderly liquidations, and there have been some bailouts of distressed banks. Gilts and treasuries rose as investors fled to quality, while equities fell because tightening credit terms made takeovers and leveraged buyouts more expensive to finance. Fears that a credit crisis could ultimately impact global growth hit oil and base metal prices.

Nevertheless, so far the impact has been less than feared, perhaps because it has been spread over a larger number of players. Reports from hedge funds suggest weak July returns, and a sharp rise in redemptions in August, but with the support of the central banks, these are hopefully containable.

Many investors are bulls who try to wrest good news out of the jaws of bad, and have resurrected the idea of a ‘Bernanke put’. In other words, if the sub-prime problems become serious, the Fed will cut the prime rate, as Alan Greenspan did in the past. Indeed the market has projected up to two 25bp cuts by March. They may be unlucky. The US economy is certainly slowing, but the Fed is not there simply to bail out investors who have made bad decisions, and the recognition of this may restrain market rallies.

On the other hand, the European Central Bank (ECB) has taken the initiative by pumping large sums into the money market. This, however, failed to calm investors, who feared that this unprecedented action must betoken knowledge that things are more serious than they thought. Apart from the sub-prime market, however, the background for equities remains supportive. The global economy remains healthy, there is no sign of earnings being downgraded and the strong rally in bonds has significantly improved the relative valuation of equities.

While mergers and acquisitions activity by private equity and hedge funds has been dented by the tightening of lending criteria, we believe that their place will increasingly be taken by sovereign wealth funds. Not all markets appear equally attractive, either fundamentally or technically. We need significant rallies in the FTSE, CAC and S&P 500 to invalidate bearish technical signals. We remain cautious of Japan, but are beginning to see signs of value in US equities. In the short term, however, we are on the sidelines, waiting for the dust to settle.

US – Slowing, Not Collapsing

Throughout this year, we have become concerned about fading US productivity growth, reflecting the steady decline in capital investment since 2001. The weak second-quarter numbers, together with the downward revision of first-quarter productivity, make gloomy reading. Second-quarter unit labour costs have risen by 4.5% year-on-year, which will put pressure on corporate profit margins until companies cut costs – probably by reducing the workforce.

Nevertheless, July retail sales remained on target, helped by weakness in the gasoline price, and this may provide some cushion to the economy in the second half. This will be needed, given that the housing market is unlikely to bottom this year. The financial sector has clearly suffered serious losses from the sub-prime fallout, but this is being reflected in the sector’s underperformance. Furthermore, despite the growing importance of the financial sector to GDP over the past 30 years, there is little statistical evidence that problems in the sector spill over into the wider economy. Despite the recent rally, the dollar remains historically weak, and this will underpin the earnings of the multinationals, whose income is increasingly derived from economies growing faster than that of the US.

UK – Strengthening Headwinds

In July, for the first time since March 2006, UK Consumer Price Index (CPI) inflation fell below the Bank of England’s 2.0% target, triggering an immediate fall in sterling as investors revised their expectation of a rate increase to 6%. This may be premature, since it reflected discounting by retailers plagued by unseasonable weather, as well as falls in utility prices that are unlikely to be repeated. On the other hand, the Monetary Committee voted 9-0 to keep rates unchanged in July, and UK average earnings growth (+3.3% year-on-year) fell to a four-year low in the three months to June.

The economy is facing stiffer headwinds than its Continental competitors because of its greater dependence on financial and business services, rather than manufacturing. The current credit crisis is likely to hit the City in terms of reduced income from mergers and acquisitions, derivatives, hedge fund activity and so on, with knock-on effects for bonuses, property demand and luxury items. On the other hand, the UK is not benefiting as much from the booming Asian and Russian demand for high-quality engineering.

Finally, the UK may soon undergo its own version of the sub-prime crisis as interest rates on mortgages taken on two years ago are reset at higher rates. These factors help to explain the relatively poor performance of FTSE, relative to Eurozone markets, over the past few months. Despite the modest valuations in the UK market, we may have to wait for the resolution of the sub-prime problems for the uptrend in UK equities to resume.

Europe – A Refreshing Pause?

Countries in the Eurozone have reported their second-quarter GDP numbers. Almost without exception, they show a loss of momentum, but we regard this not as a portent of worse to come, but as a pause before growth resumes in the second half. Unemployment levels have fallen to levels that encourage greater consumer confidence, and workers are enjoying improvements in real earnings for the first time in years.

Inflation remains under the 2% ECB tolerance level, and we believe that rates are on hold – at least until the credit crisis is resolved. We recognise that a number of financial institutions have suffered losses from investment in sub-prime assets, but this could provide the trigger for rationalising the fragmented German banking sector.

Far East – Yen Bounce

Second-quarter Japanese GDP growth was disappointing at 0.1% quarter-on-quarter, despite the strength of capital spending. Private consumption remains sluggish, reflecting both demographics and changes in tax timing. The Yen has strengthened significantly during the recent turmoil, as Japanese investors sold out of overseas equities and repatriated the currency. The fall in UK inflation, the slowdown in the Eurozone economies and the actions of the ECB all reinforced Yen strength, boosting returns in sterling terms. We do not believe that this is sustainable. Once risk appetite returns, we expect the Yen to weaken again. With the exception of the banks, corporate profits remain buoyant, but the weakness of the consumer sector and the impact of the stronger Yen on the exporters keep us cautious.

The Chinese economy shows no sign of slowdown. Industrial output grew by 18.0% in July. July retail sales (+16.4% year-on-year) grew at the strongest rate in three years, with jewellery (+45.9%) and auto sales (+42.7%) particularly buoyant. Inflation is accelerating – the CPI rose by 5.6% year-on-year in July, but we believe that the problems are largely confined to the food sector, where disease has led to a temporary shortage of pork. As a result, we do not believe that the Bank of China will react by aggressively tightening liquidity. The creation of a $200bn state fund to invest internationally will support regional Asian markets, and may well take advantage of the current market weakness to accumulate strategic stakes in major western companies.

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