Month: February 2016

When Chasing Interest, Don’t Forget Currency Risk

For many years, interest rates have been extremely low in the UK and most other developed countries. If you are living abroad and your new country’s interest rates are much higher than back home, it is natural to think about ways to capitalise on the difference. The right strategy can significantly enhance your returns, but at the same time there are risks which many expats underestimate or completely ignore.
Do You Want to Earn 0.35% or 14.35%?
At present, central bank rates are at 0.5% in the UK and the US, 0.05% in the Eurozone, and negative in several other developed countries including Switzerland, Sweden and Japan. You can get a cheap mortgage, but you also earn close to nothing on your savings. At the same time, the rates are 6% in South Africa, 7.5% in Turkey, 11% in Russia and 14.25% in Brazil, just to name a few.
Why save at 1% or less in a British bank when you can earn multiples of that just by keeping the funds in a different currency? It makes complete sense, particularly when you are living there and big part of your expenses are denominated in that currency anyway.
Interest Rate Differences and Exchange Rate Changes
You have heard it before: There is no free lunch in the markets. To earn considerable returns, you must take considerable risks. In this case, the risk is that the currency you hold will depreciate and the resulting losses will wipe out or exceed any interest gains. This risk is very real. It happens all the time.
Even with the pound’s current weakness, in the last three years the South African rand has lost 38% against the pound, the Turkish lira has lost 34%, the Russian rouble 56% and the Brazilian real 46%. In spite of their high interest rates, you would have lost money on all of them.
According to an economic theory (named uncovered interest rate parity), when there is a difference in interest rates between two currencies, it is expected (other things being equal, which they never are) that the high interest currency will depreciate against the low interest currency, so the total return will be the same on both. For example, if interest rates are at 0.5% in the UK and 14.25% in Brazil, it is reasonable to expect that the BRL will lose approximately 13.75% against the pound in the next 12 months.
Theory and Reality
In reality, other factors come into play. Sometimes the high interest currency does not depreciate that much and you indeed make money holding it. However, other times it loses much more than “expected”, as seen on the examples above.
The risk of disproportionate adverse moves in emerging currencies is particularly high at times of global liquidity shortage and increased risk aversion, such as in the 2008 financial crisis or the 1997 Asian currency crisis, which spilled over and contributed to subsequent problems in Russia, Brazil and Argentina. The problem with these events is that you never see them coming until it’s too late. Furthermore, even an otherwise stable country’s currency can often be affected only due to market sentiment and its emerging status.
What It Means for Your Finances
The above does not mean you should always keep all your savings in GBP or other major currencies. It means that whenever the currency structure of your income, expenses, assets and liabilities is in mismatch, you are exposed to currency risk. For instance, if you are living in Brazil and saving in BRL, but planning to eventually return to the UK or retire elsewhere, you are to a large extent betting your future on the BRL exchange rate.
Make sure you know what you would do in an adverse scenario, such as a currency crisis, however unlikely that might seem at the moment. Keep at least a portion of your savings in a strong and stable currency, even when the returns don’t look that attractive. It is widely known that rich families in places like China or Russia prefer to keep big parts of their wealth in developed countries, giving up the higher returns they would earn at home. They do it for a reason and that reason is safety and stability.
You can allocate some funds to high-yield currencies and riskier investments, but with the core of your assets, like the pension pot, it should be defence first. Don’t bet your future lifestyle.

Possible Brexit Consequences and Your Portfolio

Whether you support Leave or Remain, you may be wondering how leaving the EU (or staying in) can affect your investments. Will British stocks underperform if the UK leaves? Will the pound continue to be under pressure until the June referendum, but recover if people vote to stay in the EU? Is there anything you can do to prepare your portfolio for either outcome?
The Brexit referendum is a typical example of an event with known timing (23 June) but unknown outcome. Plenty of these occur in the markets on a regular basis, including corporate earnings, macroeconomic data or central bank policy announcements. While this one is obviously of extraordinary significance, the underlying principles of market psychology still apply.
One of these principles is that anticipation can result in as much volatility as the event itself (if not more). In other words, when investors know that something is going to happen, or might happen with a certain non-zero probability, the market often “reacts” before the outcome is announced. In line with the Efficient Market Hypothesis, prices immediately reflect all available information.
The pound has weakened by 9% against the dollar and by 11% against the euro in the last 3 months. It seems like big part of the damage has already been done. Will it depreciate further? It is impossible to predict.
When anticipating an event, sometimes the market overshoots and then corrects, making a counterintuitive move when the actual outcome is finally known (like the pound strengthening after the referendum even if Leave wins). The saying “buy the rumour, sell the fact” comes to mind. Sometimes it’s the opposite. Other times it’s completely random. No one can tell before it happens.
With the above being said, there are two things we consider highly likely:
Firstly, until the June referendum we will probably continue to see increased volatility in the pound’s exchange rate (saying nothing about the direction). As the first days have confirmed, the debate will be heated. New questions and new fears will arise. Both camps will achieve small victories and suffer small defeats. The perceived probability of leaving the EU will change as new opinion polls will come out.
Secondly, given the high profile and non-stop media coverage of the matter, the economic significance and consequences of Brexit are probably exaggerated at the moment by both the Remain supporters (doom and gloom if we leave) and the eurosceptics (prosperity guaranteed if we rid ourselves of EU bureaucracy).
Contrary to what it may seem, the world has not come to a standstill, waiting for the UK to decide. There are other events and other factors which will continue to influence the economy, the stock market and the currency, before and after the referendum. Some of them will probably have much greater effects than Britain leaving the EU – possible candidates include oil price (the FTSE is energy heavy), interest rates, slowdown in China or the US, wars (e.g. Ukraine, Syria) getting worse and spilling over, or shocks in the financial sector. This time last year, it was Grexit, not Brexit, dominating the headlines. The fact that no one talks about Greece at the moment does not mean that the sovereign debt problem (in Greece and elsewhere) has been resolved. It can strike back at any time and hurt British banks and the economy even if we are already out of the EU.
The above does not mean that consequences of a possible Leave vote will be negligible or non-existent. However, they are too complex for anyone to understand and forecast. We don’t know the referendum outcome. If it’s Leave, we don’t know how the future arrangement will look (in any case, the UK will not cease to trade with Europe). Most importantly, the global economy and external factors will definitely not remain constant, further complicating any predictions.
Therefore we believe that avoiding panic and sticking to your long-term investment strategy is the best course of action. Remember that trying to outsmart and time the market rarely leads to superior results.

Tax Year End Planning Checklist

The end of the tax year is approaching again; therefore it’s time to think about maximising allowances, minimising taxes and taking all the other steps to ensure your tax position will be as favourable as possible going forward. Although there are still almost two months left, it’s better to start now rather than leave it all to the last days, for some of the necessary steps can take some time to process.

When going through the checklist below, you may find this page useful. It contains all the key thresholds, rates and allowances for 2015-16 as well as 2016-17.

Income Tax and National Insurance

If possible, delaying an invoice (if you are self employed), salary, bonus or dividend payment (if you have a company) until 6 April can save, or defer, a considerable amount of taxes. Company owners should also find the right mix of salary and dividends to minimise taxes. Don’t forget to include all of them when making the decision – personal income tax, both employee’s and employer’s NI, corporation tax and dividend tax.

The key figures are:

  • £5,824 = Lower Earnings Limit – minimum to qualify for State Pension and other benefits
  • £8,060 = Primary Threshold – employee’s NI (12%) kicks in
  • £8,112 = Secondary Threshold – employer’s NI (13.8%) kicks in
  • £10,600 = Personal Allowance – basic rate income tax (20%) kicks in
  • £31,786 = higher rate income tax (40%) kicks in

Many company owners choose to pay themselves a salary equal to the Primary or Secondary Threshold, in order to avoid paying NI, and take the rest in dividends. However, if your company is eligible for the Employment Allowance (first £2,000 of employer’s NI free), it could make sense to pay yourself up to the Personal Allowance (£10,600) in salary. Of course, your other income, family situation and other circumstances could alter the figures and must always be considered.

Pension Contributions

Making pension contributions can save you a lot of money in taxes, as long as you stay within your annual allowance, which is £40,000 for the 2015-16 tax year. At the moment, pension contributions are subject to tax relief at your marginal tax rate, which makes them particularly attractive to higher and additional rate taxpayers.

Normally you need to make the contributions before the tax year end (5 April), but this time it is recommended to act before the Budget Statement, which is due on 16 March.

There is high risk that Chancellor George Osborne will announce important changes which may affect the tax relief. The exact outcome is not known, but experts have been speculating about a flat rate replacing the marginal tax rate (this would effectively reduce or eliminate the tax relief for higher and additional rate taxpayers). The Chancellor has also mentioned the idea of cancelling the pension tax relief altogether and using a completely new mechanism for taxing pensions in the future, perhaps similar to ISAs (after-tax money in and tax-free money out).

It is not clear if this will eventually materialise and when any changes would come into effect. However, pension tax relief has clearly been one of the Chancellor’s primary targets in the effort to reduce the deficit and raise tax revenue. In light of the uncertainty, the safest approach is to make pension contributions before 16 March to avoid potential disappointment.

Note that if you didn’t use your full allowance in the three previous tax years, you might still be able to get that money in, on top of this year’s £40,000. The previous three years’ allowances were £50,000, £50,000 and £40,000, respectively. One condition is that your total contribution must not exceed your earned income for the current tax year. Another thing to watch out for is the lifetime allowance (currently £1.25m, but falling to £1m in April), as exceeding that could be costly when you retire.

NISAs

If you have the cash, you should always use your annual NISA allowance to the maximum. A NISA is a tax wrapper which allows you to build savings and investments without incurring taxes on income and capital gains going forward. The allowance is £15,240 for 2015-16 and it is use it or lose it – if you don’t deposit the money by 5 April, this year’s allowance is gone forever. You may also want to use your partner’s and your children’s allowances (£4,080 per child under the so called “Junior ISA”).

If you have existing cash ISA accounts, now is also a good time to review them and check the interest rates. Banks like to lure savers with attractive rates, only to slash them after 12 months or some other period. In such case you may want to transfer the funds elsewhere. There are two things to keep in mind:

  • Always transfer from ISA to another ISA directly. If you do it via your regular bank account, once you have withdrawn the money, it loses the ISA status (and withdrawals do not increase your annual allowance – that will only change the next tax year).
  • Each tax year you can only deposit money to one cash ISA account and one stocks and shares ISA account.

Capital Gains Tax

You can often save on capital gains tax even outside ISAs. There is an annual CGT allowance, which makes the first £11,100 (for 2015-16) of capital gains tax-free. You need to realise these by the tax year end; otherwise the current year’s allowance is lost forever.

Depending on the investments you are holding, whether there are unrealised gains or losses and whether you want to sell any of them, the decisions to make can become quite complicated, but may save you a lot in taxes. A potentially large CGT bill can be reduced (by crystallising losses) or deferred (if you wait with the sale until 6 April). On the other hand, if you are well within your CGT allowance you can crystallise gains to reduce future taxes.

Always keep in mind that tax issues are an integral part of any investment strategy (and tactics), as taxes can affect net return substantially. At the same time, don’t forget to consider transaction costs.

Inheritance Tax

If your estate is likely to exceed the IHT threshold (£325,000 for individuals or £650,000 for couples), you may want to take steps to reduce it. Estate planning can obviously become very complex, but the easiest thing you can do is make gifts to your beneficiaries. These are subject to annual allowance of £3,000. If you didn’t use the allowance last year, it can still be used now (making it £6,000 in total), but after the tax year end it is lost. As long as you live for seven years after the gift, it is out of your estate.

Other Considerations

The above are the most common points which apply to most people. Depending on your circumstances, there may be other opportunities, further allowances and other things to do before the tax year end. In any case, it is best to discuss your entire financial and tax position with your adviser, as some actions might have unexpected consequences. Don’t forget the key date is 5 April, with the exception of pension contributions where it is safer to act before 16 March this year. Also remember that some actions will require longer time to process and don’t leave everything to the last days.