In this issue, we review recent tax changes impacting on individuals. We take a look at a range of investment options for those with a recent windfall, and give an update on tax efficient investment options. Plus good news on the self-investment of protected rights.
INHERITANCE TAX PLANNING - THE TRANSFERABLE NIL-RATE BAND
Legislation changes should simplify many IHT planning arrangements, especially for married couples and civil partners. We take a look at the new transferable nil-rate band.
Historically, basic inheritance tax (IHT) planning involved ensuring that the first spouse (or civil partner) to die used their nil-rate band (NRB) in full, as this would result in a substantial IHT saving (£124,800 using the current NRB of £312,000). This frequently involved setting up a discretionary trust, and care was particularly needed where a couple's main asset was their home. However, this strategy has, in many instances, changed since the transferable nil-rate band (TNRB) was introduced on 9 October 2007 in the Pre-Budget Report.
This has proved to be a popular measure and the basic principle is simple to grasp: if the first spouse dies and some or all of his/ her NRB is not used on death, the unused proportion may be transferred to the survivor, so that his/her NRB is increased on death by that proportion. For example, say John died in 1995 having used only 75% of his NRB. If his wife Mary dies in 2009, her NRB will be £325,000 (2009/10 NRB). This will be increased by the 25% unused proportion of John's NRB so she has an NRB of £406,250, thereby reducing the IHT on her estate by a further £32,500.
Exempt gifts such as those to UK-domiciled spouses or charities do not utilise the NRB. For example, if say George left his entire estate to his spouse Jill, he would not use any of his NRB. This would mean that if Jill died on or after 9 October 2007, her personal representatives could claim one additional NRB amount on her death.
It should be noted that the NRB of the survivor can be increased by no more than 100%, or one additional NRB.
The Paperwork – How To Claim
It has been possible to claim the TNRB since 9 October 2007, regardless of how long it has been since the first spouse died. Claims cannot be made if the survivor died before 9 October 2007.
The general rule is that claims should be made by the survivor's personal representatives within two years of the end of the month of death. For example, a claim must be made by 31 July 2010 if death was on 10 July 2008. In some situations, a later deadline may apply or a later claim may be accepted.
Claims should be made to HM Revenue & Customs (HMRC) on form IHT216. Supporting documentation is required but may be difficult to find, especially if the first death was many years earlier. HMRC has made it clear that the original documents or official copies do not have to be provided. Certified copies are acceptable. HMRC is looking at all claims submitted and will reject them if the information is incomplete.
This will delay agreement of the IHT due from the estate and also the issue of the grant of probate.
When submitting IHT216, HMRC needs to see the marriage or civil partnership certificate, plus the death certificate, will, grant of probate and any deeds of variation for the first deceased spouse.
Copies of certificates may be obtained from the General Register Office, and wills and grants from the Court Service. The IHT (or capital transfer tax or estate duty) account will also be needed to establish the value that passed to those other than the survivor on the first death. This value may have been liable to IHT and the account should show whether any reliefs, e.g. for business or agricultural property, were available.
It is unlikely that HMRC will still have all these records for deaths that occurred more than 18 years ago, so the personal representatives will have to do their best to find the appropriate supporting evidence. HMRC has said it will be understanding in such circumstances.
Plan Ahead
Keeping good records is now more important than ever, so it is worthwhile gathering in advance as much of the required information as possible to simplify future TNRB claims.
In many cases, the TNRB will simplify estate planning for married couples and civil partners, although discretionary trusts will continue to have a role in certain circumstances. This is particularly relevant if there are concerns about care fees or unwise second marriages, as they could provide an appropriate level of protection.
These changes highlight the need to review your will regularly to ensure it is appropriate for new legislation. If you would like help with your will or in connection with other IHT planning issues, please get in touch.
INVESTING FOR GAINS NOT INCOME - MAKING THE MOST OF THE NEW 18% CGT RATE
The 18% CGT rate means investors must look at the structure of their investments to minimise tax constraints.
Until April 2008, an individual paid capital gains tax (CGT) as though the gain (after deducting various reliefs) was the top slice of taxable income. This meant that CGT was effectively chargeable at various rates up to a maximum of 40%.
From 6 April, CGT is chargeable at the fixed rate of 18% for all taxpayers (apart from corporate entities), which is a wide disparity between this and the higher rate of income tax of 40%. Therefore, in recent months there has been much interest in investments whose gains give rise to CGT rather than an income tax charge.
Tax Treatment Of Some Mainstream Investments
Most conventional investments yield dividend or interest subject to income tax, plus there can be a CGT charge at 18% when the investment is disposed of.
However, some investments pay no dividends and all the income rolls up within the fund until it is either wound up or the investor disposes of his/her holding.
Many such funds are based offshore and those that do not distribute 85% or more of their annual income are classified as 'non-distributor funds'. Under current legislation, when you make a disposal of units in such a fund, the gain will be subject to income tax at the investor's marginal rate of tax.
Other historically popular investments are the offshore bond or non-qualifying insurance policy. They roll up income and gains until withdrawals or disposals are made in excess of a specified maximum, equivalent to 5% of the original capital invested for each year the bond has been in existence, at which time (unless the individual is not UK resident), an income tax charge will arise. Care must be taken to ensure one does not invest in a personal portfolio bond as the tax regime for such investments is less favourable.
Zero Prefs
Certain investment structures are only subject to CGT. A good example is the zero dividend preference share class of split capital investment trusts, often referred to as 'zero prefs'. Zero prefs provide no income, so no income tax charge is incurred, and on disposal are only subject to CGT. The value is rolled up within the investment, so the tax suffered on the total investment is limited to 18%, unlike most conventional investments. Zero prefs are medium-risk, cautious investments with the objective of long-term capital growth.
A portfolio of zero prefs further reduces the exposure to risk, of which the Smith & Williamson's Cautious Growth Fund is a good example. While past performance is no guide to the future, it is interesting to note that this fund achieved a cumulative performance of 32% over the past five years to July 2008.
Other Possibilities
It is also important to consider how investment decisions can be implemented without tax constraints. Pension funds, notably Self-Invested Personal Pensions (SIPPs), are perfect for this.
Those with substantial portfolios may want to consider a private unit trust. There are various regulatory and tax issues to consider but, in the right circumstances, these can be a tax efficient investment vehicle for high-net-worth individuals.
CGT-Free On Disposal
Provided qualifying conditions are met, some investments do not give rise to CGT on disposal. Venture Capital Trusts holdings and Enterprise Investment Scheme shares are the two most obvious examples, both of which, if the conditions are met, come with a range of other tax benefits.
British government stocks and gilts, which also do not incur CGT, are often overlooked. Returns are at the low end of the scale, but with the current market depression, they may be worth considering.
MULTI-MANAGER INVESTMENT SOLUTIONS - A MODERN METHOD
The attractiveness of the multi-manager solution, particularly to smaller investors, means it is no surprise to find that the number of institutions offering such a service has been increasing steadily in recent years.
A multi-manager investment approach involves entrusting investments to a number of fund managers across a wide range of investment sectors. This can be achieved by investing through either a fund of funds or into one fund, which, in turn, is managed by different managers from different disciplines.
What Are The Advantages?
The investment argument for a multi-manager approach centres around ease of dealing, flexibility, best of breed and access to institutional managers, all of which average investors could not access on their own. All this can be done within a tax-efficient wrapper, such as an open-ended investment company (Oeic) or unit trust structure.
The usual approach to a fund of funds is through a portfolio of open-ended investment vehicles. The concept of a fund of investment trusts or a fund purely constructed from zero dividend preference shares is less well known and less used, despite there being some distinct advantages to this approach.
The key advantage to a fund of investment trusts is the closed-ended structure which makes it possible to invest in assets that are less suited to an open-ended structure, e.g. property, forestry or private equity. Such assets offer opportunities for diversifying a portfolio, as they are historically not correlated to equity markets.
In addition, closed-ended structured products can offer easy and simple access to global stock markets or particular themes or sectors.
Many asset management houses view their investment trusts as flagship funds, so appoint their best managers to manage them. Shareholders of investment trusts can have their returns enhanced by balance sheet activity, such as dividend smoothing or share buybacks. They also offer the opportunity to make money in falling equity markets through investment in hedge funds. Also, discount pricing anomalies allow opportunistic dealing, which can enhance overall returns.
Tax Efficiency
The zero dividend preference share class of a split capital investment trust offers investors capital gains only. A fund of zero dividend preference shares gives more cautious investors a diversified portfolio within an extremely flexible and tax efficient structure. Although such a fund will lag the broader market in a bull phase, it should perform well in less certain times.
Smith & Williamson has been successfully managing several funds of investment trusts for a number of years, with our Global Investment Fund having just received an industry award in recognition of consistent performance. Our Dublin-based fund of zero dividend preference shares also offers a broad exposure to this asset class.
THE REMITTANCE BASIS OF TAXATION IMPORTANT CHANGES TO NOTE
The Finance Act 2008 changes radically the operation of the remittance basis of taxation.
All UK residents, irrespective of domicile, are taxed on the arising basis on UK income and gains. The remittance basis of taxation is an alternative basis for taxing relevant foreign income and, for foreign domiciliaries, employment income and foreign gains.
From 6 April 2008 the remittance basis rules changed fundamentally and basic issues, such as the definition of what constitutes a remittance, have been extended significantly. The rules are complex but here we touch on some areas of importance.
Anti-Alienation Provisions
Prior to 6 April 2008, the law allowed a foreign domiciliary to alienate foreign income and gains by making an offshore gift to an individual (such as a close relative) or an offshore vehicle. As the income had been alienated the transferee was then able to remit the gift to the UK and, provided the transferor did not receive a monetary benefit, there was no deemed remittance.
Special anti-alienation provisions have been introduced for foreign income and foreign chargeable gains arising or accruing from 2008/09 onwards. Broadly, a remittance is deemed to have been made by the individual to whom the foreign income arose or the foreign gains accrued where a person with a specified degree of connection with the individual either:
- remits funds representing or derived from foreign income
or foreign chargeable gains to the UK, or
- receives any UK benefit directly or indirectly derived
from foreign income or foreign chargeable gains.
Importing Goods To The UK
The rules with respect to what constitutes a remittance have been extended significantly. All property imported into the UK that is derived from foreign income or foreign chargeable gains, represents a remittance unless:
- the transitional provisions apply
- the property derives from relevant foreign income and has
a notional remitted value of less than £1,000 (this
means that less than £1,000 of relevant foreign income
was used to acquire it)
- one of the four specific relevant rules applies (the
public access rule, the personal use rule, the repair rule
and the temporary importation rule).
Services Performed In The UK
Unless a special services exemption applies, a remittance now covers the offshore payment of fees for services performed in the UK. Where the exemption is in point, it applies regardless of the source of the funds used to make the payment. For the exemption to apply, the services' condition and the payments' conditions must be met. Broadly, the services must be wholly or mainly (over 50%) in connection with foreign property, and the payment must be made by a direct transfer to the UK service provider's offshore account (or an offshore account held by someone else on behalf of the relevant service provider).
Payment for travel costs when travelling into and out of the UK is not covered by the exemption and consequently does constitute a remittance.
Source Ceasing
For remittances occurring after 5 April 2008 (regardless of when the relevant foreign income arose), the Finance Act 2008 overturns the principle that there can only be a taxable remittance of relevant foreign income where the source existed in the tax year of remittance. There will not, however, be a charge with respect to funds derived from successful source ceasing exercises, which were brought to the UK before 6 April 2008. This is the case whether or not the funds remain within the UK.
The Need For Advice
The changes are so radical that an individual relying on advice obtained when he/she first came to the UK, and before the rule changes, could find themselves non-compliant and might inadvertently make remittances which, if specialist advice had been obtained, could have been avoided.
If you are affected by the changes, we would be pleased to provide practical advice on how you can structure your affairs and investments tax efficiently under the new regime.
PROTECTED RIGHTS - GREEN LIGHT FOR SELF-INVESTMENT
Restrictions will be lifted allowing SIPPs to hold protected rights from 1 October 2008.
Protected rights are benefits payable at retirement age derived from funds built from rebated National Insurance Contributions (NICs) and paid into an appropriate personal pension plan by the Government. These benefits are a substitute for part of the State Second Pension (S2P).
The ability to contract out of the S2P has been with us for more than 20 years and it is not uncommon to find individuals with accumulated funds of between £20,000 and £50,000.
At present, individuals cannot transfer their protected rights into a SIPP, the view being that rights intended to replace state benefits foregone should not be subject to the risks that can arise from self investment. However, existing restrictions preventing SIPPs from holding protected rights will be lifted on 1 October 2008.
Individuals with existing SIPPs will be able to transfer their protected rights plans into their SIPPs, giving them more investment flexibility as well as fewer pension plans to administer. In turn, SIPPs can hold a wide range of investments, which can be managed by the pension fund member, his/her nominated investment adviser or a stockbroker. These changes will help make clients' affairs simpler going forward.
It will be interesting, however, to see whether the changes will have a damaging effect on the investments held by insurance companies which have, traditionally, managed protected rights funds. A mass exodus to SIPPs would be another blow to insurers, following hard on the heels of changes to the CGT rules, which have made their investment bonds less attractive from a tax perspective.
If you would like to explore whether your protected rights funds should be transferred elsewhere, we would be pleased to advise you.
INVESTING NEW-FOUND WEALTH - WHAT YOU CAN DO WITH A LARGE LUMP SUM
The recent changes to CGT rules led many investors to realise assets ahead of the new regime. We discuss what people can do with their new-found cash.
As an investor you have a wide range of options open to you when faced with the decision of what to do with a large lump sum of money. You should first decide whether your objective is income, growth or a combination of the two. If it's income, how much do you need?
Weighing Up The Risks
The next step is to assess the level of risk you're prepared to accept. Given the implications of the credit crunch, even cash deposits at some banks carry risk, so timescale has become very important. If you do not need your capital for, say, five years or more, you can afford to take more risk, provided that your income needs are met.
Cautious investors may gravitate towards cash or bonds. Cash deposits can be structured by, for example, using single premium investment bonds to enhance net returns – particularly for higher-rate taxpayers. There has been growing interest in 'quality' bonds, such as those provided by the Government, which run on a conventional and index-linked basis – although rates may not be exciting enough for 40% taxpayers.
Beating inflation is a priority for many investors. If this is the case, Index-Linked National Savings Certificates can be useful. They offer 0.35% per annum above inflation, tax-free over five years. However, there is a cap of £15,000 per individual. Alternatively, a nine-year index-linked gilt provides a net real yield of around 0.8% above inflation for a 40% taxpayer.
Take Your Chances
More risky, but of interest to some investors, is the concept of absolute rather than relative returns, i.e. your investment aims to grow even if markets are falling. However, check the details and find out, for example, if the product 'bets' on markets through derivative trades or using hedge funds.
Structured products also compete in this space by offering protection of your initial capital and giving a return linked to the performance of, for example, the FTSE- 100 Index over, say, a five-year period. These products rely on the quality of the ultimate capital guarantor, so avoid those with ratings below AA.
Equity investment either in individual stocks or through collective funds such as unit trusts and Oeics is another option, but again, remember the risks. Returns are dictated by market movements and results are heavily influenced by asset allocation. For example, if your investments are UK-biased and the UK market falls by 10%, you will suffer.
Don't Delay
Given the maze of investment options, advice is essential. But perhaps the biggest risk is leaving new-found wealth on deposit where it loses value over time. Inertia is not an option.
CORPORATE BENEFITS - THE EMPLOYEE'S PERSPECTIVE
All employers should be able to offer an attractive benefits package. What should staff be looking for?
Corporate benefits were once considered the preserve of large organisations, but recent developments in the market mean that this is no longer the case. Everyone has different needs, so a good benefits package will try to accommodate these within the overall reward structure. This should, in turn, be designed to attract, retain and motivate staff.
NIC Savings
Does your employer offer benefits by way of a salary and/or bonus sacrifice arrangement, enabling you both to save NICs? This is probably the easiest and most cost-effective way for any company to offer benefits. They legitimately use the tax rules to everyone's advantage and the vast majority of companies are now moving to offer their pension benefits on a salary sacrifice basis. Many reinvest their own NIC savings as an additional pension contribution for their employees. Childcare vouchers are another popular benefit that can be offered by salary sacrifice.
Pensions
Not only is a company-sponsored pension arrangement extremely attractive, the nature of the scheme is important. With final salary pension schemes becoming more and more rare, the latest hot topic is SIPPs. Does your company give you the option?
Know What You're Getting
It may be that your employer has a comprehensive benefits package in place, but do you know the value of it? One of the most useful tools is a total reward statement confirming your salary, pension contributions, the premiums paid for life assurance and the value of non-monetary benefits.
There are a number of benefits that employees can pay for themselves at no cost to the employer, such as membership of discount clubs. Employees should strongly consider joining executive share schemes or share incentive plans provided by employers, as these offer rewards linked to the success of the business.
Flexible Benefits
Innovation in computer software and expansion in the offering from benefits providers mean that flexible benefits arrangements are now available to even the smallest of organisations.
Businesses should weigh up how beneficial a flexible solutions package will be in terms of staff retention and maintaining a competitive remuneration package.
It is not possible to list here all of the benefits that an employer can offer. But Figure 1 lists the major ones and may indicate whether or not your employer is providing an up-to-date range.
Fig 1: Survey of the most popular choices from typical flexible benefits schemes
|
Pension |
79% |
|
Private medical insurance |
32% |
|
Holiday trading |
17% |
|
Pension – voluntary contributions |
14% |
|
Share incentive plan |
14% |
|
Life assurance trading |
13% |
|
Dental insurance |
5% |
|
Childcare vouchers |
4% |
|
Income Protection – flexibility of cover |
3% |
|
Retail vouchers/discount card |
3% |
Source: Aon Consulting's UK benefits tracker (six months to January 2008)
Ultimately, our advice to employees is that if you want something, bring it to the company's attention.
THE TAXPAYERS' CHARTER - MODERNISING TAX ADMINISTRATION
Plans for a new Taxpayers' Charter and to modernise tax administration will hopefully make the whole system easier for everyone.
On 19 June 2008, HMRC announced a consultation on its proposals for a new Taxpayers' Charter and published two consultation documents on modernising tax administration. These are part of the ongoing series of 'Modernising powers, deterrents and safeguards' and it is apparent that HMRC sees an important connection between a charter and the modernisation of its powers.
New Taxpayers' Charter
The consultation document identifies three issues.
- Rights and responsibilities
- Broader values of HMRC in its relationship with
taxpayers
- Service standards that customers can expect
The suggestion is that the charter will be a stand-alone document and not enshrined in law. It seems entirely sensible to adopt this approach for the detailed issues concerning rights and responsibilities and also for the broader values of HMRC and service standards. However, we believe the core principles with respect to the rights and responsibilities of taxpayers should be enshrined in primary legislation.
The importance of the work on modernising powers cannot be overstated. Getting the balance right, and being seen to get the balance right, so that taxpayers have appropriate safeguards and rights of appeal is vital. For taxpayers to have trust in the tax authorities they must feel that they have a remedy should HMRC officers behave inappropriately. There is real concern that the Finance Act 2008 has gone too far in increasing the powers available to HMRC. A Taxpayers' Charter, where the fundamental over-arching rights and responsibilities of taxpayers is enshrined in statute would redress this balance. It would also ensure that we have a system that enables HMRC officials to do their job while providing the appropriate safeguards for taxpayers.
Meeting The Obligations
This consultation paper considers taxpayer behaviour and the reasons for late filing and late payment of tax.
It compares the existing sanctions available against a set of model principles which would influence taxpayer behaviour for the better. In light of the work done so far, HMRC has commissioned external research on how taxpayers react to different actions by a tax authority. These findings will be publicly available in due course.
The report includes some fascinating statistics. For the 2006/07 financial year, HMRC collected around £423bn and repaid around £73bn. Of this total, approximately £64bn was paid late by taxpayers, although the majority of that figure was paid shortly after the deadline. HMRC was due to receive almost 23 million returns covering all the taxes, but some 3 million of those were filed late or not at all. Approximately 1.7 million late filing notices were issued to individuals, of which 153,000 were subsequently cancelled. No doubt a number of those were raised incorrectly, but it is clear that late filing and late payment are significant issues for HMRC.
Penalty Deterrents
The paper compares the existing range of sanctions for late filing and late payment against the design principles. It notes that capping the penalty to the amount of unpaid tax was introduced as an additional safeguard for those with low liabilities, but it appears that it has had a significant unintended effect on behaviour – taxpayers make an estimated payment of tax by the filing date and then delay filing the return until later.
In the case of income tax self-assessment, more than half of the 1.7 million fixed penalties issued in 2006/07 were capped, resulting in significant extra work for HMRC.
The document comments that although a fixed penalty on income tax self-assessment provides a clear message, the £100 late filing penalty has remained unchanged from day one and is not a deterrent for serial offenders. The report proposes that a further fixed penalty, possibly at a higher level than the first, would become due a month or so later. This would be followed by a more robust tax-geared penalty later.
The report considers the difference across the various taxes, noting that while there is a surcharge for income tax unpaid 28 days after the due date, there is no sanction for late or non-payment of corporation tax. It suggests aligning the penalty structure and considers a possible system for all taxes that includes escalating fixed penalties, escalating tax-geared penalties or a combination of both.
On the specific issue of taxpayers failing to pay their tax on time, the overriding conclusion was that people generally put other financial priorities first. In the case of businesses, it was noted that payments would probably be made first to those creditors who could stop critical supplies to the business if they were not paid.
Interest – Working Towards A Harmonised Regime
This report starts with the premise that interest is not intended to be a penalty for late payment – it is merely recompense for the time that money is in the wrong pocket. It states that interest should provide recompense for loss of use of money both ways. Accordingly, the interest regime should be responsive to changes in market rates and the interest rate should be set at such a level that paying late is not advantageous. Furthermore, the regime should be understandable and cost effective to administer.
The report makes the point that all interest rates are currently set by reference to formulae; each tax has its own formula and there are currently nine formulae in total. For some reason the current rate of interest on income tax is 7.5%, whereas the rate for corporation tax is only 6%. Not only do companies pay a lower interest rate than individuals, but interest charged on late paid corporation tax is an allowable deduction.
In the case of some taxes, interest is charged as soon as payment is late, for others, only when under-declarations are assessed and, in some cases, there is no interest charge at all. A business which owes several different taxes will need to decide which tax it is best to pay first, either because there is no interest charge if it pays late or because one charge is lower than another.
The report considers possible features of a new interest regime. It suggests that moving to just one interest rate would remove the opportunity for arbitrage between different liabilities. It suggests that interest on indirect taxes should be charged automatically on under and overpayments and the interest regime should be extended to those areas where no interest is currently charged or paid. This category includes in year Pay As You Earn (PAYE) deductions by employers, although the report recognises that a significant restructuring of the PAYE system will be necessary before interest could be charged in these circumstances and this could result in additional administrative burdens for employers.
The report also considers the appropriateness of the current system of 'simple interest' and the differential between interest charged on tax paid late and interest added to overpayments. It seems that this is an issue that needs wider discussion. While moving to compound interest would mean that interest would be charged on interest, there nevertheless could be a significant improvement in the clarity of a statement of account if it were possible to move to a credit card type statement.
All in all the consultation is welcomed and it is hoped that the new charter will achieve its objectives
INVESTMENT OUTLOOK – AUGUST 2008
World Markets
Remaining Volatile
The extreme investor pessimism recorded in the two most recent Merrill Lynch surveys of fund managers and the historically high levels of liquidity finally triggered a powerful, if short-lived, relief rally in global financials when recent results of some US banks beat depressed expectations. A sudden downward move in oil prices from record highs reinforced and broadened the rally. This does not mean that we are out of danger; even though equity valuations in most markets are at historically attractive levels, this is not a typical economic slowdown. Evidence abounds that the credit crisis is affecting the real economy. Large companies are squeezing their small suppliers and banks are putting pressure on borrowers seeking scarce capital to transfer other banking business to them as a condition for receiving a loan. Interest rates are rising for loans repayable in 2009 as lenders become increasingly fearful of economic conditions next year. Regulators could compel banks to take up to $5trn of assets back onto their balance sheets, and to provide more capital against risky assets, further imperilling their ability to make loans. Investors are becoming increasingly reluctant to recapitalise banks that have either denied that they have problems or have come cap in hand for the second or even third time.
In July, the US banking regulators put IndyMac into 'conservatorship' – an American euphemism for nationalisation – making it the second-largest banking failure in American history. The US government is trying desperately not to have the status of Fannie Mae and Freddie Mac changed – in other words, it does not want to formally assume responsibility for their debts.
Falling equity markets have also reduced pension fund returns, putting pressure on companies to top up their funds to meet future obligations at a time when their cash flow is under pressure. Dividend growth may disappoint.
The economic data point to a sudden and serious slowdown across the Western economies over the past quarter, and while markets would respond favourably to further weakness in the oil price, we believe that the ongoing credit crisis and increasing evidence of the pressure on consumers would cut short any rally.
USA
Still Slowing
Food inflation is starting to bite, with leading manufacturers looking to raise prices by 12-20%. The Fed is beginning to sound a bit more hawkish on inflation, but with unemployment rising, consumers are unlikely to be able to offset fully these costs through higher wages. The benefits of the tax rebate will be swallowed up by inflation, not by increased sales volume.
The Chicago Fed National Activity Index remains deep in recession territory, and the Conference Board Leading Indicator is in decline. Better durable goods orders and new home sales, and a rebound in consumer confidence following the fall in the oil price are not enough to turn around the economy. The downturn in the property market has left state legislatures with a $40bn hole in current year budgets, forcing them to cut jobs and services.
The results season is well underway; companies with large export sales or overseas interests have generally done well, thanks to previous dollar weakness, but those close to the US consumer have disappointed. We expect equities to remain volatile.
UK
So Much For Prudence
Even the most myopic must now see Gordon Brown's economic miracle for the charade that it really is. His cynical manipulation of the economic goalposts to justify public sector overspend has caught him out, now that the economy is slowing or perhaps even contracting. Borrowings are set to soar well beyond his 40% of GDP ceiling, but his successor has had to make a number of U-turns that have deprived him of additional tax revenue. The economic downturn is gathering momentum. Asking prices for homes in July showed the biggest monthly fall since 2001. June's rise in unemployment was the largest for 16 years. Factory orders are weak. The number of financially troubled companies has tripled between Q2 2007 and Q2 2008, and the problems are not confined to the usual suspects – construction, transport and retail – but have extended to IT, engineering and manufacturing. With estate agents, retailers, pubs and restaurants closing, the owners of the underlying properties are under pressure to cut rents or lose tenants. Demand for business properties is at the lowest for a decade, at a time when significant new properties are coming on to the market. Ultimately, this will result in rising defaults at the banks. The latest round of utility price increases will add to consumers' problems. We see a difficult year ahead; now is not the time to try bottom fishing, even though low equity prices are encouraging bid activity.
Europe
Still Slowing
The trend of slowing growth and rising inflation is becoming well established. Q2 German GDP showed a decline relative to a Q1 number that was boosted by exceptionally favourable weather, but other European economies recorded similar declines. In Germany, falling unemployment has emboldened the unions to strike for higher wages, squeezing profit margins already under pressure from a strong euro and weaker demand from overseas. In Spain, a major property group, Martinsa, has collapsed, with debts of $8.6bn, unemployment in the construction sector is soaring and the economic slowdown will put the Government budget into deficit. Q1 construction output in Ireland fell by 21.6% yoy. Unfortunately the European Central Bank seems more concerned with inflation than growth, and is disinclined to cut interest rates.
Wage growth per Eurozone employee hit an eight-year high in Q1 of 3.1% yoy, well above productivity growth of 1%, and given the automatic wage indexation to prices in Spain and Belgium, there is a risk of inflation becoming entrenched. We remain negative on Eurozone equities.
Far East
Where's The Trigger?
Visa restrictions have hit airline and hotel bookings in Beijing, and continuing high levels of air pollution are proving a public relations problem for the Chinese leadership. Fears of a serious post-Olympics slowdown in China are overdone, however, given huge ongoing infrastructure investment, and the Government has responded to weaker export demand by slowing the rate of currency appreciation. The rest of the region continues to suffer adversely from oil and food based inflation, but while we believe this is significantly discounted in current share prices, we lack a trigger for a sustainable rally during the summer doldrums. The Japanese economy remains sluggish, but the equity market is cushioned by realistic valuations and the likelihood of increased inflows from Post Office savings.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
