June 2008 Newsetter...click here for full PDF version

Balancing act
UK interest rates are 5.00% following the Monetary Policy Committee’s (MPC) last move in April. The cuts were implemented in spite of worries over continued high inflation, in the belief that staving off an economic slowdown is more important. Many had hoped for further cuts as the credit crisis fallout helped bring inflation back into line. However, that was before the latest inflation reports. Mervyn King, Head of the MPC has indicated that higher energy, food and import prices will keep inflation high in the next few months and that the maximum limit of 3% will be exceeded. He believes it should fall back towards the Government’s target rate of 2% over the medium term but, in common with the European Central Bank, the MPC is tasked with controlling inflation rather than economic growth. The latest figures therefore seem to limit the ability to implement further interest rate cuts without very careful thought. The MPC also has to consider that interest rates are becoming less effective for controlling inflation. Banks have not passed on all the rate cuts to consumers because they source a lot of their lending finance from the inter-bank market, where rates have remained high. Response to the Chancellor’s calls for lenders to pass on cuts has therefore been muted. The Bank of England’s bond swap proposal has eased the situation a little. If, as is hoped, this helps to rebuild the battered confidence of recent
months, the existing interest rate cuts may be enough.

Q: How much tax...
...do I really pay on an ISA investment?
A: There is no liability to personal income or capital gains tax on the profits made by any ISA investment after it is paid out to you. Similarly, no tax is paid on interest earned by your cash ISA or on interest payments from corporate bonds and gilts within stocks and shares ISAs. You do not even have to declare its existence on your tax form. However, tax of 10% will be deducted from all dividends and 20% from any interest earned on un-invested cash within a stocks and shares ISA before it is paid out. This will also apply to former PEPs.

Investing for growth
The make-up of your investment portfolio will depend on a number of factors, most importantly your age and attitude to risk. Age, for example, helps to indicate your time horizons, which will indicate whether you can ride through the volatility of equity markets. Your attitude to risk will then decide whether you can deal with that volatility and how much diversification you need to help soften any potential downturns. If you do not require an income from your investments, then you will be looking to invest in assets which will maximise the capital value of your portfolio. If you have a longer time horizon (for example, during the earlier years of pension planning) then it could actually pay you over the long-term not to be too cautious. Equities have traditionally outperformed all other asset classes over the long-term and therefore, despite their tendency for high volatility over shorter periods – you can lose money if markets turn against you – some of that long-term potential could be missed if you do not take a least some of that risk on board. If you do get nervous when equity markets slump or you have a shorter time horizon then you could still get equity market exposure – you just need to be careful about what sort of equities you choose. Longer term, you could perhaps afford to look at higher risk areas of the market, such as smaller companies and emerging markets, for a portion of your portfolio (perhaps 10-15%) but over shorter periods – or for more cautious investors – a core holding of larger UK and international equities might be more appropriate. The balance of your portfolio is then likely to be targeted at fixed interest and cash. The idea here is that first, you have cash on hand to meet any short term or emergency spending requirements and second, if equity markets do go through a slump, the other assets should shelter at least some of your portfolio from the worst effects. The lion’s share of this portion is likely to be in safer corporate bonds with the remainder in cash or near-cash investments such as UK gilts. However, for the more adventurous, high yield bonds could offer some capital growth potential in the right market conditions. A well planned growth portfolio can see you through all sorts of market conditions providing you do not need the investment at short notice. Most investors lose out only if they have to – or feel they are forced to – sell assets when a market has slumped. You should always keep an eye on market conditions, but planning at the outset is much more important if your money is going to work as hard as it can until you need it.

Markets in turmoil
Investors continue to look at 2008 with apprehension. The last few months have seen the collapse of the US sub-prime mortgage market, the credit crunch, and the nationalisation of a UK bank. Speculation over the severity of the fallout continues to dominate headlines. Fears about the escalating oil price and food price inflation have only made matters worse. Across the board, the credit crunch has led to a sharp increase in the cost of borrowing which has stalled mergers and acquisitions. Although many companies are in relatively strong financial shape, some – particularly smaller companies – may find tighter credit conditions hard. This could lead to job losses and higher unemployment figures. On the consumer side, what was a booming housing market gave UK homeowners confidence and, in hindsight, a perhaps overinflated sense of wealth. However, the housing market is now at a standstill as the Royal Institute of Chartered Surveyors suggests activity has hit at a 30 year low. As a result, sentiment amongst equity investors has taken a huge knock. Bad news dominates so selectivity and realistic expectations will be important. Markets remain highly volatile, but it is worth remembering that stock markets tend to be driven by irrational fear (and greed), not logic. The key is to stay calm, think long term, and be selective. In the words of Franklin D Roosevelt, “the only thing we have to fear is fear itself”.

A Vanishing Market
Until relatively recently, credit was cheap and easily available, and mortgage lenders were fighting to win business. However, since the credit crunch took hold last year, it has become increasingly difficult and expensive to borrow. New mortgage approvals for house purchase declined to 58,000 during April as steepening mortgage rates deterred first-time buyers from entering the housing market. Remortgages were up slightly but still down on February. The increased risk that borrowers might default on their mortgage payments has spurred mortgage lenders to tighten their lending criteria. In its recent Credit Conditions Survey, the Bank of England warned not only of a decline in the availability of mortgages, but also of a likely increase in the rate of defaults. Several lenders have reduced access to their mortgages and those with decent offers are being overwhelmed. First Direct temporarily stopped mortgages to new customers while it cleared a backlog and Abbey has now withdrawn the last known, straightforward 100% deal 'to maintain high service levels'. The Bank of England has cut interest rates to 5.00% in an attempt to support growth. Despite this, some lenders have still raised their mortgage rates. Short term, both borrowers and lenders are likely to suffer but, longer term, the banks and building societies will probably use this opportunity to clean up their lending books, thereby emerging in better shape.

How much in equities?
Asset allocation is a very individual science and it is difficult to say how much you should invest in equities by just looking at a table or punching figures into a computer. There are a number of different considerations – your age, your attitude to risk and your objectives, your family set up, your immediate plans and the current conditions in the market. However, given these caveats, there are some guidelines you might want to use to get you started. At its most simple, for example, some experts start with 100 minus your age. So if you were 40, you would be aiming for 60% in equities - and at 60, aiming for 40%. Certainly it is true that a lower allocation is more appropriate as you get older - it takes you a long time to build up a pension and it would be a serious waste to have the whole lot eroded by any last minute down-turn just as you were about to retire. However, if you are younger, having too little in equities could mean you miss out on the longer term growth opportunities which they can offer. The type of equities is important too. Larger companies tend to work globally and are therefore not limited to the fortunes of one economy. Smaller companies, on the other hand, may concentrate on one particular sector or be based in an emerging market, and could grow very quickly, perhaps against the trend of global markets. However, all equities can go down as well as up and smaller companies carry an even higher risk. Make sure you are fully informed before you make a decision.

Be among the first
People often leave their ISA decisions until the last minute, driven by the March deadline. However, this year, you could make a 'new tax year resolution' and instead be one of the first to make a decision. Your allowance for 2008/09 is £7,200 which can be spread across cash and stocks and shares or all placed in stocks and shares. And getting in early could mean you benefit more than waiting - particularly for Cash ISAs which earn more interest the longer they are invested. If you prefer stocks and shares but are worried about the ups and downs of the market, perhaps you could try drip feeding your investment over the
year by using a regular savings plan.

Little and often for a big reward
In the world of investment, timing is everything. However, no matter how much hype we hear to the contrary, it is a fact that no one can predict what the market will do or when. This makes it difficult, not only deciding when to invest but also when to pull those investments out of the market. This is where the benefits of pound cost averaging come into play – or in layman’s terms, regular savings. The theory is that by regularly putting smaller amounts of money into a fund or other investment, the risk of getting your timing wrong is reduced. Compared with punting an entire large lump sum in one go at a single price, the risk is mitigated by the fact your smaller sums will buy in at a variety of prices. In a rising market, regular savings would underperform the growth of a single lump sum as the later investments would miss out on that rise in the early days. However, in an up and down or falling market, the opposite is true. Later investments would buy in at lower or alternating prices – some lower than the original price - and would therefore gain a little more when the market finally did rise. Similarly, regular saving is a great way to build up a lump sum from zero. A lump sum of £5,000 can seem a tall order for some people. However, putting aside £100 a month from your income is less of an issue – and with investment growth or interest added you can quickly build up a reasonable sum. The longer you leave it, the more impressive that potentially becomes. Most investment products offer regular savings as an option - investment funds, ISAs, life assurance and pension plans. If you are considering equities for the first time, this is also an ideal way to start as the small amount you miss every month has less impact on your lifestyle – and you will be less sensitive to the short-term ups and downs of markets as falling prices give a chance to buy the same investment at lower prices.

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