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  1. How will rising interest rates affect you?

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    Bank of EnglandThe Bank of England’s Monetary Policy Committee (MPC), which sets the UK’s official interest rate, meets eight times a year. Its job isn’t to control interest rates, it’s to control inflation. Inflation goes up when we spend more money, which grows the economy.

    The MPC has just announced a rate rise for the first time in a decade, setting rates to 0.5%, and increase of 0.25%.

    How will that potentially impact your finances?


    For savers it should be good news of course, with other banks following Threadneedle Street and raising their rates too. After a decade of rock bottom interest payments, this will be welcome relief; but bear in mind that the difference in reality is negligible: If rates rise by the predicted 0.25%, that would mean only an extra £25 each year on a £10,000 cash ISA.

    It’s a step in the right direction, but savers won’t be breaking out a ticker tape parade just yet.

    Property owners & buyers

    When interest rates go up, the cost of buying a house becomes more expensive because the cost of a mortgage goes up. Property is a fixed-income investment, and when interest rates rise, fixed income investments go down in value.

    I anticipate a stabilisation of the property market rather than a big fall, demand is so high that I don’t see a big crash, rather a levelling out of price growth (as we’ve already seen with stamp duty increases). And as with savers, the impact of a 0.25% rise is unlikely to be huge unless you have a mortgage in the high six- or seven-figures.

    Pension holders

    Pension investments typically have three assets: fixed income, property and equity. Fixed income assets (such as bonds or gilts) tend to go down when interest rates rise, so if you’re heavily invested in fixed income you may expect your portfolio to drop in value. Property, as we’ve discussed, also tends to come down in value.

    As for equities, when interest rates rise they tend to go up in value. Broadly speaking, when inflation increases, companies charge more for their products; which increases their profits; which means they’re worth more; which increases their share price.

    So if you’re heavily invested in fixed income or property in your pension, expect it to fall in value when rates go up; otherwise, an interest rate rise should mean you’ll see your pension continue to rise.


    PensionsIf you’re a low-risk investor, you’re likely to have a majority of your portfolio in fixed interest and bonds, so the interest rate rise will have a negative effect for you.

    However, not all fixed interest items act the same (despite what you may have heard): it depends on whether they’re short-term (around three years), medium-term (five to seven years) or long-term (up to 15 years) assets.

    When interest rates rise, short-term fixed interest assets are not affected; and medium-term ones only a little so. A more significant impact is seen for long-term loans, because of how bonds work. The longer the time until I’m due to receive my money back from the lender, the more can happen in that time to influence the bond’s price, which will reflect the interest rate in the open market.

    Bonds – the basics

    Company X is looking for investment, so they launch a bond. You give them £100 for 5 years; they agree to pay you 5% annually, or £5 in this example; and then at the end of the 5 years they give you your £100 back.

    Interest rate rises do not affect short-term bonds because you’re going to get your money back in a matter of months or a few years, a timeframe when there are unlikely to be major changes that will affect the value of the bond.

    Long-term bonds have much higher volatility – they act like shares – because we can’t predict what’s going to happen over a longer period of time. If interest rates rose sharply from the 5% example above, then you might be able to get 10% interest on a savings account with a high street bank; so why would you want to continue holding your bond? I’d want to sell it and put my money in the bank where I could get £10 annually instead of £5. So the bond price with company X might drop from £100 to £50, because now when I get my £5 annually from the bond, it’s at the same 10% interest rate as I can get in the bank.

    Most pension funds are invested in long-term bonds, so their value is likely to go down when interest rates go up.

    How Lexo protects your portfolio from interest rate rises

    At Lexo, our portfolios are specifically designed to mitigate the effect of interest rate rises, because we only use short- and medium-term bonds in them (and we’re considering removing the medium-term element).

    For us, the fixed interest elements are there to reduce volatility, not produce a return – that’s what the stock market elements of our portfolios are for.

    Maintain your long-term vision

    It’s easy for investors to think, ‘Because stock markets are likely to go up as companies increase profits, even though I’m a low-risk investor, I can see interest rates will rise for the next few years and I don’t want to miss out so I’ll increase my stock market exposure.’

    That would be a mistake.

    If you’re a cautious investor, your portfolio should always reflect your attitude to loss; how much you feel you can lose. You might want to move away from long-term bonds into more medium- or short-term ones, but your equity exposure should only reflect the amount you’re willing to lose. Roughly speaking, a 100% stock market exposure investment will fall by as much as 50% in the case of a crash.

    You shouldn’t get dazzled by any potential returns or the effect you think interest rate rises might have in the future. You should invest in a portfolio that’s commensurate with your level of risk, and just stay invested. As a wise man once said:

    “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

    Paul Samuelson, economist (1915-2009)

    Overall, to reiterate: we’re only talking here about a 0.25% increase in the interest rate. These things happen slowly, and that rise won’t have a massive effect. You may not see much change at all in your portfolio for a while yet!

  2. How the Economic Machine Works – by Ray Dalio

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    Ray Dalio runs the worlds largest hedge fund – the Alpha Fund with more than $169bn in assets, he has been crowned one of the worlds most successful investors of all time, founding Bridgewater Associates in 1975.  Here is his take on how the economy works – he’s worth listening to!

  3. Britain’s Decision to Leave the EU Doesn’t Mean You Should Exit Your Long-Term Financial Plan

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    Britain’s decision to exit the European Union was a shock to many and has brought with it all the expected trappings of a wild news event – projections of crazy market volatility, doom gloom, recessions and wild headlines.

    Many questions immediately arise as we pay close attention to how the event will play out in the weeks and months to come. But our perspective is the same as it has always been in times like these. Your financial plan is built with diversification and your personal risk tolerance in mind — it’s designed to weather the ups and downs that inevitably follow significant world happenings.

    1.       What did British voters decide?
    To the surprise of many – including stock and bond markets – Britain voted to leave the European Union (EU) by a margin of 52 percent in favour of leaving (i.e., “Brexit”) and 48 percent in favour of remaining. The general belief from the economic community is that this decision will weaken the British and European economies since Britain both imported and exported a significant amount of its economic consumption and production, respectively, to continental Europe.

    2.      How have markets reacted?
    At the time of this writing, stock markets have fallen and bond interest rates have dropped as well. With the exception of precious metals, commodity markets are also generally down, and the Pound has dropped by about 8 percent against the U.S. dollar.

    3.       Why have markets reacted so violently?
    Without question, the primary reason is that markets had incorporated a belief that Britain would remain in the EU. Stock markets had been up significantly over the last couple of weeks, and interest rates had started to move back up after being lower earlier in the month. These movements were generally believed to be an indication that the market expected Britain would remain in the EU.

    Because the vote did not go as most expected, stock markets are giving back those gains and more, and interest rates are now falling instead of increasing. I should emphasise, though, that while these market moves have been swift, this is normal market behaviour when a significant event (like Britain leaving the EU) turns out differently than what the market had anticipated.

    4.      Why have the international markets reacted so strongly to Britain’s decision?
    We truly live in an interconnected, global economy at this point. Any decision by an economy that is the size of Britain’s (fifth largest in the world) will impact markets elsewhere, including the U.S. market. The European market is a significant trading partner for many U.S. firms, so it’s not surprising to see U.S. and international stocks decline since Britain’s decision is thought to be a net negative for Europe from an economic perspective.

    5.       Will Britain’s decision precipitate a global recession?
    It’s impossible to say whether we are headed toward a recession, but Britain’s decision likely increased the likelihood of a recession. However, the strong caveat here is that markets are forward looking and have already started to incorporate this likelihood, meaning you can’t use this information to your advantage. This increased likelihood of recession is no doubt one of the reasons that stock markets have moved down sharply while bond prices have moved up sharply.

    6.      How did markets get this wrong?
    While outguessing markets is difficult, in hindsight markets will always appear to have been overly optimistic or pessimistic, which means it’s easy to critique them while looking in the rearview mirror. This particular vote was expected to be close, so markets weren’t certain but were trending toward a “remain” vote.

    7.       What will markets do from here?
    While it’s very difficult to predict markets, it is highly likely markets will be volatile for some time to come. Stock market volatility has been relatively low over the last few years, but it can change quickly. The VIX, which is a measure of annualised stock market volatility, has gone from about 17 percent to 25 percent in reaction to the news, which is higher than the long-term average of about 20 percent per year.

    It is important to remember, however, that higher volatility can work in both directions. While we could certainly see more days when stocks fall significantly, it’s also possible we will have days when they rise significantly.

    8.      What should I do with my own portfolio?
    Our guidance is the same that it has always been. If you have built a well-thought-out investment plan that incorporates your ability, willingness and need to take risk, you should not change your plan in reaction to market events. Doing so rarely leads to productive results.

    Your plan incorporates the certainty that we will go through periods of negative market returns, and market reactions like this are also the primary reason we emphasise high quality bond funds and bond portfolios, which help buffer the risk of stocks. The early read on this bond approach is that it’s doing exactly what we expect it to since high quality bonds have appreciated significantly in reaction to the Brexit vote.

    9.      How will this impact interest rate policy?
    As we have previously noted, interest rates have dropped dramatically in reaction to the vote. At the closing bell on Friday, the 10-year yield was at about 1.088 percent after having been at about 1.376 percent one day earlier. These early movements in interest rates indicate the market does not expect the Bank of England to increase interest rates at any point during the rest of the year. The primary ways this would likely change are either an unexpected increase in the rate of inflation or unexpectedly positive developments in the British and global economy.

    10.   Do international and emerging markets stocks still deserve a place in a well-diversified portfolio?
    International and emerging markets stocks comprise more than half of the world’s equity market value, so we continue to believe that a well-diversified stock portfolio should include a significant allocation to international and emerging markets stocks. While both have outperformed British equities over the last 10 years – international also over five years, that does not mean they will continue to do so. We have seen periods in the past when British stocks have outperformed international and emerging market stocks for a long period of time only for that to reverse in the future.

    11.   What role do currencies play in this situation and in my portfolio?
    Initially, we are seeing the British pound depreciate against the Euro and U.S. dollar.  The international equity funds we use do not hedge foreign currency, so when the British pound depreciates relative to other currencies, this positively impacts their returns. The long-run academic evidence, however, shows that hedging currency risk has minimal impact on an overall portfolio and that it can be beneficial to have exposure to currencies other than the British pound for a portion of an overall portfolio.

    12. Yield Curve
    A yield curve shows the yield or ‘interest’ payable on varying term fixed interest securities (typically Gilts/government bonds).  Shorter term normally have a lower yield than longer term fixed-interest securities.

    Research beginning in the late 1980s documents that the slope of the yield curve is a reliable predictor of future real economic activity i.e. a recession predictor. Today, a substantial body of evidence exists from which various useful stylised facts have emerged.

    An inverted yield curve is often a predictor of a recession. At present, although the reducing, the 3-month yield vs 10-year yield remains positive.  Typically yields become inverse or the difference is negative 3-6 months before a recession occurs.

With investment, your capital is at risk. The value of your portfolio with Lexo can go down as well as up and you may get back less than you invest. It is important that you understand the risks. Lexo aims to provide information to help you make your own informed decision. It does not provide personal advice based on your circumstances. If you are unsure, please seek personal advice from Lexington Wealth.

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