Post the Labour conference we are beginning to get a sense of the way Rachel Reeves’ thinking is developing.
Since the new administration took power, we have heard very little about the growth agenda which was an important part of the election campaign. Instead, we have seen a very gloomy picture painted, with the previous government blamed for a supposed £22bn black hole and the frankly unhistorical suggestion that the economy was in an unprecedently bad state. We have also seen a lot of money thrown at the public sector unions to try to sort long-running industrial problems, along with other measures which, whatever their other merits, would be a stretch to think could contribute to growth (e.g. much tighter employment rules, the non-dom saga, the shutdown of new North Sea oil and gas projects). And behind this the drumbeat of higher taxes to pay for the project, possibly affecting all taxes except those that had been safeguarded in the manifesto.
The various proposals for tightening up on tax have unsurprisingly been met with pushback, and some from unexpected quarters- the French government has objected to VAT on school fees, as have the parents of many Special Educational Needs and Disabilities (SEND) children. In some cases the pushback seems to be from within the Treasury, as for example on the way the non-doms are treated. This is an interesting case study as the rhetoric has changed from this being a tax raiser (but now becoming apparent that it may well not be) to it being a matter of social justice. If (as is now thought) the loss of tax revenues from the departing wealthy will be as much as the extra tax from those staying, there must logically be a net loss of spending in the economy, as not only will we lose all the spending of those departing, spending by those who remain will also be reduced given the increase in tax take.
We are furthermore starting to see some pushback from the lawyers, which will bring a wry smile from ministers in recent governments who have been hamstrung by judicial reviews. Challenges to school fee VAT on the basis of Human Rights may be just the beginning The bonfire of planning controls will not go through without a lot of court time.
Whether this will make a difference at the end of October is questionable. As I write there are conflicting reports on whether, or to what extent the Chancellor has decided to tighten the rules. On the assumption that at least some change will be implemented to meet manifesto commitments, even if watered down, we may end up with the worst of all worlds: an exodus and a negligible increase in tax from those remaining.
Without knowing which taxes will be altered, what can investors do to protect their portfolios?
It now seems clear that there is going to be a rethink on how to define the government’s self-imposed debt ceiling by the Cunning Plan of redefining investment. And maybe pretending that losses on Bank of England bond holdings do not matter. There are technical and theoretical merits to this, however the bottom line is that it means more borrowing. More bonds for sale imply higher rates for longer. As the IFS pointed out, changing the debt rules is not a risk-free plan. Mervyn King, former Governor of the Bank of England, said on 30 September that interest rates are in the right ballpark. The siren voices from bond fund promoters stating that rates are coming down and bond prices are therefore going up should be treated with caution.
- Laddered fixed income portfolios of issues with staggered maturities can provide certainty of income and return.
It is now widely assumed that CGT will rise. The questions are largely around whether there will be a restoration of any sort of indexation and what other exemptions may be put in place. Intuitively if you increase the tax on capital you will get less investment, so it is hard to see how it can fit into a growth agenda- but it is also hard to see how much of a priority that agenda really is. We have already seen significant crystallisation of capital gains, along with drops in share prices that are not driven by any adverse developments (even after positive developments)
- Where you have them, take capital gains ahead of the budget, with a view to reinvesting in due course.
One break that has not been questioned in the press is EIS (and VCT structures). Investment into shares issued under the enterprise investment scheme (EIS), which provides income tax relief, capital gains tax relief as well as inheritance tax relief (as long as the shares are held for the required time) will look more attractive if these reliefs remain in place whilst other taxes rise, assuming the underlying investment case is sound.
- Investors should focus on companies which are financially and commercially self-sufficient and in control of their own destiny, and not just on the tax benefits.
For the AIM (and Aquis) markets the big threat is a reform of business relief, the so-called IHT exemption. As we have previously noted, the Office of Tax Simplification under the previous administration had suggested that giving AIM companies a tax break designed to benefit small family companies and family farms was not necessary. However, the exemption does exist and has led over time to a considerable amount of investment being directed to AIM, therefore removing it would be very damaging.
AIM has already significantly underperformed vs other markets for a number of reasons, including ever tighter risk-management rules which have led to restrictions on institutions’ holding sizes as well as a lack of liquidity in the market with market-makers’ access to capital diminished. This has led to lacklustre share price growth even on good news and outsized price swings on company updates, leading to less investor interest further exacerbating the problem.
The Times headlined their story on the potential removal of the exemption (30 September) the “Nightmare on AIM Street”. Investment industry figures have been pointing out, both publicly and in private, that removing it would create a major funding problem for smaller UK companies. According to Peel Hunt analyst Charles Hall, simply removing it for any future investments (so not retrospectively) would create a £1bn funding gap: in broad terms he has stated that IHT funds deploy around £1bn per year gross, and pay out about £500m/year to the estates of deceased investors, providing a net inflow of £500m- which would become an outflow of £500m if the exemption were closed.
Again, some tightening up might be the outcome- possibly a maximum company size, or a maximum amount that an estate could claim. Similar restrictions could be applied to other business relief qualifying assets, such as farmland.
What if the IHT relief did go, in its entirety? Undoubtedly the AIM market would sell off, and there would be a possibility that it would finish it as a serious place to raise money. That in turn would create huge problems for institutional portfolios as the post-Woodford guidelines on liquidity would potentially force further selling. The AIM market-makers, who are not particularly well capitalised, would widen spreads and drop the bids to discourage activity. The IHT funds tend to have congregated at the higher capitalisation end of the market so size would not be a protection.
However, low prices call forth buyers (ultimately). The worst thing to do would be to sell into the panic. Better capitalised companies will see the opportunity to make acquisitions within their sector. There may be some private equity interest. Ideally one should have some dry powder to add to positions in profitable companies if their shares are available at distressed levels. The alternative would be to buy into better managed AIM funds in a panic- an interesting example in those circumstances would be Harwood Capital’s North Atlantic Smaller Companies Investment Trust, managed by Christopher Mills. Mills has built a good record by taking large positions (up to the 29.9% permitted by the Takeover Code) in investee companies, taking board positions, and driving change. The trust already trades on almost a 24% discount to NAV. Closed end funds tend to underperform in a panic as the assets fall and the discount to net asset value rises.
- Keep dry powder to invest into a panic.
Good times just around the corner? Perhaps the Growth Agenda will emerge. Rachel Reeves insists that she wants to work with businesses. There is no shortage of constructive ideas being floated – among others a revival of the “Brit ISA” with minimum levels of onshore investment (as the old SIPPS had) which the previous administration suggested (after all, why give a tax break to investing in non-UK companies?); enhanced investment in equities by the British Business Bank, and the new Wealth Fund; direct investment in relevant equities by Great British Energy; a commitment to making the Mansion House agenda work, channelling pension money into private and AIM/Aquis companies; and higher limits on EIS and VCT qualifying companies to stop the cliff-edge of follow-on funding that hits companies just as they start to grow.
- Look for sectors within the market which would benefit if Rachel Reeves’ bonfire of planning rules does work and liberalisation of building rules lead to a bonanza for construction companies and building material suppliers. Energy supply is another area where planning has been a problem and where liberalisation may create opportunity.
We must hope for the UK that we do not continue with a structure of regulation and organisation that has driven pension funds out of the domestic market and seems to be doing the same to individual investors.
