Stock market recovery continues - because or despite US Fed meeting and UK budget?

18 March 2016

As the stock market recovery of the developed world continued and levels got ever closer back to where they had started the year, the US Fed's March meeting as well as the UK's annual budget ritual had the potential to stall the upward momentum. Neither did and indeed both were fairly positively received by capital markets.

Globally more important was whether the US central bank, the Federal Reserve (Fed) under its chair Janet Yellen would or would not raise interest rates for a second time, as originally envisaged when they raised first back in December. They did not, as had been very widely expected, but at the same time chair Yellen also stressed that the committee had not observed a significant deterioration to the upward trend of the US economy since their December meeting. When pressed about the likely timing of the next rise she even said that April remained a '˜life' meeting, which means that if better data was to be forthcoming, then the next rate rise could be quite soon.

However, more importantly the so called '˜dots plot' which illustrates the expectations of the FOMC members' about future levels of US interest rates (see chart at the bottom of next article) has now come much closer towards what implied market expectations suggest - at least for the near future. For the longer term the Fed still sees the '˜terminal rate' (I.e. the highest we will get to) of this cycle to reach a maximum level of 3.25%, whereas the markets expect only 2.5%. US stock markets reacted with tepid gains, which means that the Fed managed to get their message just right - no surprises, no increased uncertainty. Well done Mrs Yellen.

In the UK, of course, the annual Budget of the chancellor Georg Osborne received all the media attention, although in total it didn't bear particularly positive or negative surprises in my opinion. It felt that in the run-up to the EU in/out referendum the government is keen to give the electorate no reason to vote '˜out' just because they dislike latest policy decisions. In the past I have not commented much on the budget, given the very comprehensive media coverage it receives. However this budget turned out to have more relevance for private investors than average and therefore it is worth looking at the changes from our perspective.

Firstly, the reduction of capital gains tax rates from 28 to 20% for higher rate tax payers and from 18 to 10% for lower rate tax payers increases the attractiveness of investing amounts in excess of the annual ISA allowance. It is also notable how tax rates on income and capital gains derived from investments are all converging around the 20% mark for higher rate tax payers and 10% for lower rate payers. Together with the annual capital gains and dividend allowances of £11,100 and £5,000 p.a. respectively, this means that only investors who take annual withdrawals in excess of £100,000 from their investment portfolios will ever even pay the 10 or 20% tax that remains.

Altogether this should now make income versus CGT tax considerations largely redundant when deciding between total return and income maximising investment approaches. Furthermore, the increase of the annual ISA allowance from currently £15,240 to £20,000 from 2017, means that the next generation of investors should - by and large - be able to move all of their ongoing savings into this UK specific tax wrapper. It was notable however that buy-to-let property investments are excluded from the new lower CGT rates, so as not to encourage even more investment in the already very highly valued UK residential property market.

The introduction of the Lifetime ISA (Lisa?) on the other hand will complicate the decision making process for the general public and has the potential to undermine the pension auto-enrolment process through misguided opt-out out decisions. The first reason for this is the poor grasp the general public has of percentages. Under auto-enrolment the employer - depending on company size - has to contribute 1-3% of an employee's wages to their pension, as long as the employee contributes the same from their (pre-tax) pay. Under the LISA the government will top up any annual LISA investment of up to £4,000 (from taxed monies) with a maximum of £1,000 or 25% (!). I can just see how people will get confused and wrongly see the 25% government LISA contribution as the better deal than the employer 1-3% contribution (which is obviously a 50% top up and also pre-tax).

But even for advice professionals it will become near impossible to advise whether it might be more beneficial to top up the pension contribution beyond the employer matching of 1-3% through salary sacrifice, but then pay income tax on pension withdrawals in old age, or do the £4,000 LISA contribution first and receive the government top-up and withdrawals from this pot tax free in old age. I suspect for those who remain lower rate tax payers throughout their life the traditional pension top-up through salary sacrifice will be slightly more beneficial because NI is additionally saved under salary sacrifice, whereas for higher rate tax payers it will be totally nebulous and depend on lots of if's and but's.

Two important messages can be taken away, however. Firstly the government believes that the public may save more towards their pensions if there is some access to the savings for other important funding requirement (LISA savings will be accessible for deposits towards first homes - see later article for more details). Secondly, the current pension approach of tax and NI deductibility of contributions appears to be on the way out and the LISA concept has given us a first flavour of what to expect. For now the old system is still in existence and I expect even more people to use their remaining pension allowances of the current and what they have left from the past years to improve their pension funds on a pre-tax basis before it is scraped either in the autumn or in next year's budget.

The other elements of the budget have been well covered elsewhere and here only 2 points which I would like to add: The further reduction of corporation tax to an EU wide very low 17% (by 2020) may be a precautionary measure to keep businesses domiciled in the UK in case the Brexit referendum - against the odds - returns an '˜Out' vote. On the actual budget side, it strikes me that despite all the austerity and '˜not spending more than we have' talk, what the government is actually aiming for is a reduction of the public sector, with savings going straight back into large-scale investment like all the big rail projects. At least this is what the combination of the lowest public sector headcount in decades, unchanged levels of public debt and a fairly unchanged overall tax revenue relative to GDP tells us.

To my mind it is a missed opportunity that the chancellor has shied away from telling the public that there are times when it does make sense to increase government debt if it is for investment to increase the country's long term GDP potential, even if the public sector in general still feels the pain of previous budget cuts. I suspect that with his '˜austerity to reduce debt burden' narrative of the past years he fears he would lose public support entirely if he now increased the government deficit and debt levels again, even if it is for investment and at yield costs which are currently below the long term rate of inflation.