We’re at the point now where about the only potential tax hike that hasn’t been run past the committee of public opinion is a revival of the 200-year old window tax.
Don’t laugh! It could be a real revenue spinner in our era of skyscrapers in the City and bifold doors in the suburbs.
In the meantime, a rise in income taxes in the upcoming Budget seems to finally be – maybe – on the agenda.
Yes, those same higher income taxes that were ruled out ahead of the last election.
I have my doubts, but who knows. Perhaps Rachel Reeves and Keir Starmer believe the situation really is dire enough to warrant breaking the pledge? It’s already motived them to lift their silence on the £100bn hit to the economy – and the resulting black-hole-sized £40bn shortfall in state revenues – that Brexit has cost us.
Or maybe Labour thinks they might as well be hung for a sheep as a lamb, considering the kicking they got anyway for dancing around taxes on ‘working people’ with the last budget?
Or maybe it’s just another ill-advised attempt to scare us with a worst-case scenario so that the real medicine doesn’t taste so bad.
We’ll find out on 26 November. But hell will hath no fury like the voting public if income tax rates rise by a bald 2p in the pound without a ‘sterilising’ 2p cut in National Insurance – which would undo much of the revenue-raising potential anyway.
And cutting national insurance won’t help the legions of vote-happy pensioners…
A stitch in time
I happen to believe that from a bunch of very unpalatable options, just hiking the basic rate of income tax and getting on with it wouldn’t be the worst.
But that would be partially on the grounds that it’s such a game-changer that it could have quashed the rumours and uncertainty caused by chipping away at absolutely everything else – from pensions, ISAs, dividends, and capital gains to property and the rest – to the sidelines.
However we’ve already had another three or four months of uncertainty. It’s made people save more, spend less, dither about moving house, and thrown yet more sand into the wheels of our lacklustre economy.
Worse, we’ve already had last year’s employer’s NI hike. Which had exactly the effect everyone predicted it would on youth employment, and on the health of the hospitality sector too.
If a bandaid was going to be ripped off then 2024 was surely the better time to go for it.
Rumour treadmill
Here’s a flavour of this week’s speculation:
Chancellor refuses to rule out manifesto-breaking tax hikes – Sky
NIESR: hike income tax by 2-10p in the pound – This Is Money
How much would a 2p income tax rise cost you? – Which
But that’s just a taste. I’ve run batches of budget speculation in these links for weeks, so thick and fast and indiscriminate have they come.
Of course what’s notably missing from most of the rumour-mongering is anything about spending cuts. I’ve probably read more about the two-child benefit cap being lifted – which will obviously cost yet more money – than on any mooted plans to curb spending.
It’s true the last round of so-called austerity under George Osborne didn’t do much for the UK. And perhaps it’s senseless to look to downsize government – or at least to stop it growing further – while the economy is only limping along.
But is this a different era? Rates are taking their time to fall, and we’ve borrowed much more money. There’s a growing feeling that we’re sleepwalking into a self-fulfilling prophecy.
I used to look forward to budgets. But I honestly just want this one to be over.
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Defensive asset allocation is trickier than the growth side of the equation. For the latter, you can just strap on a global equity tracker for portfolio propellant and be done with it. But there isn’t a universal ‘dark times’ asset class that reliably protects your wealth from economic misfortune.
A portfolio is exposed to multiple threat vectors: inflation, deflation, stagflation, recessions, and stock market bubbles. Fending that lot off requires a multi-layered defence. If the first line fails then perhaps the next will soften the blow.
Your choice is complicated by your personal risk exposure. For instance, inflation is typically a bigger threat to retirees than young people. The young are more exposed to recessions and periods of joblessness.
It makes sense therefore to strengthen where you’re personally most vulnerable – loading up on the assets most likely to counter your own financial arch-nemesis.
Know your enemy
Here’s a quick summary of portfolio pathogens paired with their most effective treatments:
Handy though the table is, it’s missing nuance, and a generous sprinkle of ‘ifs’ and ‘buts’. Fear not: they’re coming next!
Gold, for example, looks like the ultimate wealth-preserver. I’ll have six sackfuls, please! But there are reasons to doubt it, too. (See the gold section below).
Defends against: Demand-led slumps such as economic contractions, recessions, depressions, deflation, and stock market drawdowns.
Vulnerable to: Surging inflation and fast-rising interest rates.
Younger investors
Long maturities theoretically provide the best diversification for equity-heavy portfolios. Although it doesn’t always work out that way in practice.
Older investors
Favour shorter-dated bond maturities because longer-term government bonds are highly vulnerable to inflation and fast-rising interest rates. Such shorter-dated govies may be less effective in a downturn but offer a better overall balance of risks. They’re more resistant to spiralling inflation and interest rates.
Diversification options
Global government bonds hedged to the pound
Pros: Diversification across advanced economy government debt. Choose if you’re wary of having 100% exposure to the credit risk of the UK Government. Hedge them to offset the risk of adverse currency movements that swamp your bond returns.
Cons: Higher OCFs than gilt funds. Less crash protection due to lower durations. Indices tilt towards high-debt countries such as Japan, Italy, and the US.
Cons: Corporates don’t perform as well as govies during most downturns. Essentially because countries can withstand economic peril better than companies.
Individual nominal gilts
Pros: Opportunity to target particularly useful bond issues. For example, investing in specific gilts can reduce your tax burden outside of tax shelters. Extremely long maturities may be especially potent equity diversifiers. No management or platform fees.
Cons: Require more hands-on management and a good understanding of bond mechanics. Not all brokers enable you to invest online.
Useful to know
High-grade (or high-quality) refers to bonds with a credit rating of AA- and above (or Aa3 in Moody’s system). Check out our bond terms post.
Bond maturity / duration: a brief guide to risk
The following table sketches out the three term-related bond risk categories:
Longer maturities imply longer durations, though other factors are in play as well.
Duration is the key metric when judging high-grade government bond risk. Your bond’s duration number1 is an approximate guide to how big a gain or loss you can expect for every 1% move in its yield.
For example, if a bond’s duration number is 11, then it:
Loses approximately 11% of its market value for every 1% rise in its yield.2
Gains approximately 11% for every 1% fall in its yield.
Read our piece on rising yields to understand how bonds respond when interest rates rise.
Index-linked government bonds (high-grade, domestic)
(Also known as ‘linkers’ in the UK)
Defends against: Inflation. Index-linked bonds also generally do okay in recessions but they aren’t as effective as nominal bonds.
Vulnerable to: Fast-rising interest rates (see below). Deflation – index-linked gilts lose nominal value when the RPI index falls as they lack a ‘deflation floor’. On the other hand, they won’t lose real value in this scenario, which is what counts most.
Snag: Index-linked bond funds can be real-terms losers in inflationary periods. That happens when steep interest rate hikes cause fund prices to drop. Sometimes the resultant capital loss is so severe that it drowns out the inflation-adjusted gains of the fund’s underlying bonds. The problem is solved by investing in individual index-linked gilts.
Individual linkers hedge inflation if held to maturity. Linkers still fall in price when interest rates rise but will make good the capital loss by their maturity date. Ignore that paper loss and each linker will ultimately return RPI plus the real yield on offer when you bought in.
In contrast, bond funds routinely sell their holdings before maturity. This causes losses in rising rate conditions (and gains when rates fall). The process doesn’t doom index-linked bond funds to lose against an equivalent portfolio of individual linkers over time. But it can make them a relatively poor inflation hedge.
Beware that if you buy individual linkers on negative yields – and hold to maturity – then you’re accepting an annual loss in exchange for broader inflation protection. In this scenario, the bond’s link to RPI means its value will rise to match inflation. However, the price you’d pay here for that inflation matching would be the negative real yield at the time of purchase.
Thankfully, real yields are now positive, so you’re covered against double-digit rises in inflation and you can make a small annual profit on top.
Younger investors
Can ignore index-linked gilts on the grounds that equities outperform inflation in the long run.
Older investors
Individual index-linked gilts held to maturity are the most reliable way to hedge inflation. If you use funds to hedge inflation then choose short-dated ones because long bonds are hit harder by soaring rates.
Useful to know: Don’t get hung up on index-linked gilts lacking a deflation floor. The UK hasn’t experienced annual deflation since 1933.
Diversification options
Short-term global index-linked funds hedged to the pound
Pros: Off-the-shelf convenience. Should outperform nominal bond equivalents during bouts of unexpected inflation.
Cons: Other countries’ inflation rates won’t perfectly match the UK’s. Interest rate risk interferes with inflation-hedging capability as described above. Currency risk issues if the fund isn’t hedged to GBP.
For options, see the Global inflation-linked bonds hedged to £ section of our low-cost index funds page.
Index-linked gilt funds
Pros: May perform when interest rate rises aren’t a major factor. Aligned with UK inflation. No currency risk.
Defends against: Stock market drawdowns, surging inflation, recessions, simultaneous falls in equities and bonds.
Vulnerable to: Volatility, small changes in demand, lack of fundamental value, myth-making.
Snag: Gold’s versatility looks incredible – like the everything burger of defensive assets. Yet there are reasons to be wary.
For one thing, gold’s track record as an investible asset is relatively short. That’s because it was subject to government control until 1975.
This means that unlike with bonds and cash, we can’t see how the precious metal performed during World Wars, depressions, and multiple inflationary episodes. There’s a danger that gold’s impressive history is flattered by a small sample bias. (Gold has only racked up 50 years as an investible asset class versus more than 150 years for other defensives.)
Moreover, beware being bedazzled by gold’s recent amazing run. Dig a little deeper and you’ll see that the yellow stuff fell 78% in real terms from 1980 to 1999.
Another concern is that physical gold returns aren’t linked to intrinsic value. Equities provide a claim on the future cash flows of productive businesses. Government bond interest is paid by tax revenues. Even commodity profits can be traced back to ‘roll return’ and interest on collateral.
In contrast, your gold gains are dependent on someone deigning to offer you a higher price than you bought in for.
Thus it’s worth asking if current gold prices are sustainable? Are they being driven by fundamental sources of demand? Or are waves of performance-chasers being suckered in by a succession of all-time highs? What happens when gold’s momentum falters?
The irresolvable nature of these questions underlies my caution about gold. For a (much) deeper discussion see the excellent Understanding Goldpaper by Erb and Harvey.
Younger investors
Consider a 5-10% allocation for diversification purposes.
Older investors
Consider a 5-15% allocation for diversification purposes. Remain wary of overcommitting due to the question marks hanging over gold’s short track record and its high current valuation levels.
Diversification options
Gold miners: You’d have to be insane to think of miner stocks as a defensive asset class.
Gold future ETCs: WisdomTree Gold (Ticker: BULL) invests in gold future’s contracts and has seriously underperformed its physical counterparts since inception.
Silver: Appears to be a less powerful defensive diversifier because demand is more closely tied to economic activity.
Snag: Commodities are highly volatile and typically a liability during economic contractions when demand evaporates for raw materials. Diversification is key so choose broad commodity ETFs not single commodity funds.
Younger investors
Can ignore commodities on the grounds that equities outperform inflation over time.
Older investors
Potentially the best portfolio diversifier against inflation. Whereas index-linked gilts match inflation by design, commodities can massively outperform by nature. Commodities are especially potent when the cause of the price shock is global supply chain shortages – as occurred after each World War and post-Covid.
Diversification options
Single commodity ETCs
Pros: None – excessive idiosyncratic risk.
Cons: Studies show that a basket of diversified commodities significantly outperforms any single commodity over the long-term.
Defends against: Demand-led slumps such as economic contractions, recessions, depressions, deflation, and stock market drawdowns.
Vulnerable to: Inflation, low interest rates.
Snag: Cash has delivered the lowest historical returns of any of the defensive diversifiers on our menu. Carrying too much cash will probably hold back your portfolio over time.
Younger investors
The flight-to-quality effect means longer-dated bonds are more likely to prop up an equity-dominated portfolio in a crisis.
Older investors
Cash is a useful complement to bonds. Cash won’t spike in value during a crisis but neither will it plummet when interest rates rocket. But beware the ‘money illusion’ effect when interest rates look good but are largely wiped out by inflation.
Pros: Highly responsive to interest rates. There’s no need to keep on top of Best Buy tables when interest rates are rising because MMFs automatically reinvest into higher-yielding securities. The opposite is true when rates are falling.
Cons: Riskier than cash. Money market funds can struggle to meet investors’ demands for their money back under extreme conditions. MMFs aren’t covered by the FSCS bank guarantee. (Your platform may be covered by the FSCS investor compensation scheme.) Management and platform fees.
Pros: Like money market funds they are highly responsive to interest rates. Backed by the UK Government so safer than MMFs.
Cons: Must be held to maturity – usually one, three, or six-monthly terms. Not covered by the FSCS bank guarantee. (Your platform may be covered instead.) Platform fees.
Defence in depth
If you’d like to see the multi-layered defence concept in action then check out our posts on:
The All-Weather portfolio which has demonstrably dampened some of the world’s worst stock market crashes.
Ultimately, a simple equity/bond portfolio was shown to be too simple by the events of 2022. Just swapping nominal bonds for cash is probably not ideal either. Money market funds have been soundly beaten by bonds in the long run.
What we know for sure is that all of the defensive asset classes we’ve covered above work some of the time. But none of them work all of the time.
They each have uses and flaws. As we never know what’s coming around the corner, the answer is surely diversification.
Blogger 3652 Days has a great post up about why they’re shifting more of their money into private market investments, writing:
As a passive investor, I’m supposed to do nothing. Ideally forever. Also: I dislike thinking too much.
But public markets keep shrinking – fewer IPOs, more delistings, and an ever-increasing proportion of capitalism conducted behind NDAs and closed doors.
So, in a lapse of principle, I’ve been buying shares in listed private equity vehicles and management outfits – Oakley Capital Investments (OCI), Brookfield Corp (BN), and Blackstone (BX), to name a few.
This is the private equity exposure accessible without the $5 million minimum investment, a Cayman lawyer, and a relationship manager who calls you by first name and means it.
It is, admittedly, a semi-active decision. But then, so is breathing.
I’ve long identified the same trends in markets. For good or ill, as an active investor it’s a lot easier for me to shuffle some money into different pockets of the private space, whether it be through crowdfunded investments, or via some of the vehicles that 3652 Days discusses in their article.
But purely passive investors face a quandary with private markets. Investing widely in private companies is a very different proposition to buying into a basket of public companies via an index tracker.
Not only in the many technical ways that 3652 Days outlines. But also because by definition when you buy a private asset you cannot lean so much on the wisdom of the crowd (the public market) to assume you’re (usually) paying something like the appropriate price.
It’s a big existential divergence. It also potentially brings company analysis and fund manager skill back into the picture, which inevitably means higher fees.
No wonder the financial services industry likes private and alternative assets…
The fees on private funds are much higher than for cheap index funds. And as I explained above, private assets are always more opaque and illiquid.
Yet if we run the trend to stay/go private to its logical conclusion – and public markets continue to shrink – then we could all end up paying more in annual fees to hold much the same equity mix we once got cheaply via a tracker. And we’ll have far less idea about what we own and what it’s worth for the privilege.
Maybe this is what ultimately defeats the rise of indexing and passive investing?
The zero-sum maths of active investing in public stocks is irrefutable. So perhaps financial services simply changes the game instead.
A world where a huge proportion of our money goes into private market investments – and into the pockets of private managers – would be a step backwards for everyday investors.
Run to the logical conclusion, it’d mean we’d pay more for less transparent and likely less comprehensive diversification than we already get today from trackers. And yet with all that private money pooled into big pots, you’d not even have the fun of pursuing a 100-bagger.
We’re not there yet. We can still diversify widely via index funds. And it’s too soon to be sure that listed small caps are underperforming simply because the best start-ups are remaining private.
However the push to private (both in equity and debt) is for now the clear direction of travel. So take some time to read the roadmap at 3652 Days.
