MARKET & FUND COMMENTARY 01.2014 During the quarter ending January 2014, the JSE All Share Index fell by 0.6% during a volatile and uncertain period. Resources (RESI20) rose 5.3%, industrials (INDI25) fell 0.8% and financials (FINI15) declined 7.4%. Globally, equities were battered as emerging markets took the brunt of further Fed tapering and mixed economic data out of developed markets, with the MSCI World Equity Index (US$) rising 0.2% while the Global Government Bond Index (US$) fell 1% during the quarter. Foreign capital outflows wreaked havoc within SA fixed income assets during the quarter. The SA Listed Property Index declined 9%, with the fall on the All Bond Index settling at 3.5%. The SA Preference Share Index rose by 4.6% during the period, leaving cash as a valuable source of dry powder at 1.2%. The Rand depreciated by 10.5% against the USD during the quarter, whilst declining 13.2% against the GBP. SA CPI increased by 5.4% in December on a year ago with wages, fuel, ZAR weakness and electricity prices expected to push inflation through the upper CPI target band in the year ahead. The decision by the SA Reserve Bank to raise the Repo Rate by 0.5 percentage points was unexpected given the worsening domestic economic growth profile, and while not expected to have much impact on ZAR depreciation, the impact on the economy is more concerning. Table 1: Total return of selected SA indices to 31 January 2014 Quarter 1 Year 3 Years 5 Years 10 Years SA Equity -0.6 14.9 16.3 20.4 18.6 Top 40 0.0 15.8 16.4 20.2 18.2 Small Caps -1.5 19.7 19.0 21.4 22.6 Resources 10 5.3 4.7 1.6 10.3 12.6 Industrial 25-0.8 26.9 29.8 29.5 24.6 Financial 15-7.4 7.4 18.3 21.2 16.9 SA Property -9.0-0.3 15.9 17.4 22.5 SA Bonds -3.5-2.7 7.9 7.5 8.8 SA Prefs 4.6 3.3 5.1 8.7 - SA Cash 1.2 4.7 5.0 5.8 7.1 Rand / US Dollar 10.5 24.0 15.7 1.8 4.7 Rand / Euro 9.9 23.0 15.1 2.7 5.4 Rand / GB Pound 13.2 28.4 16.7 4.2 3.6 Source: I-Net Bridge & Cordatus Capital The biggest risk/source of uncertainty we face in the short-term is the timeline and quantum of a tapering off and eventually, halting of the quantitative easing QE policy that has been followed by the US Federal Reserve. In addition, domestic equity valuations, elections and foreign perception as to policy and labour stability in SA are expected to keep risk at elevated levels.
While some ZAR stability in the short-term is likely, we expect the ZAR to have a weakening bias for the foreseeable future and when coupled with relatively more attractive valuations to be found internationally, we retain material offshore exposure within segregated client portfolios and the unit trust funds we manage, as appropriate. Our view of the global financial complex over the next decade is still firmly in place. Namely, that equity and property exposure is preferred, with longer-dated Government bonds and cash, our least favoured asset classes. Capital flows remain critical to the prospects for emerging market currencies and assets, with SA being particularly vulnerable in this regard given the budget & current account deficits we currently run. Locally, economic growth has moderated as consumers face tighter credit conditions, household debt levels become elevated and confidence has weakened due to the impact of industrial action and the recent hike in interest rates. We expect SA real GDP growth of between 2% and 3% over the next couple of years on the back of recovery in the primary and manufacturing sectors, which while encouraging, is insufficient in our opinion to deal effectively with the employment, unrest and deficit problems we face. SA needs to take advantage of a weaker rand! Table 2: Returns on Cordatus Portfolios ending 31 January 2014 Month Quarter 6 Months 1 Year 2 Years (ann) 3 Years (ann) Cordatus SA Equity Portfolio -2.8-1.0 8.6 15.5 17.6 16.4 3 Laws Climate Change Equity Pres Fund -1.9-2.3 8.9 n/a n/a n/a Benchmark [1] -2.4-0.6 11.1 14.9 19.2 16.3 Cordatus Global Equity Portfolio [GBP] -1.9-2.3 1.1 10.3 n/a n/a Benchmark [2] GBP -3.0-2.2-1.1 12.7 n/a n/a Prescient Wealth Balanced FoF A1-0.7 1.8 10.4 18.7 n/a n/a Benchmark [3] -1.5 0.5 8.6 13.5 n/a n/a Prescient Wealth Income FoF A1-0.1 1.2 3.9 7.7 n/a n/a Benchmark [4] 0.6 1.7 3.4 6.8 n/a n/a Cordatus Worldwide Flexible Pres FoF A1-0.3 2.4 10.4 n/a n/a n/a Benchmark [5] 1.0 2.2 4.5 n/a n/a n/a Cordatus Worldwide Flexible Pres Fund A1-0.7 5.4 16.2 n/a n/a n/a Benchmark [5] 1.0 2.2 4.5 n/a n/a n/a A current fact sheet for each of the above portfolios is available at www.cordatus.co.za\downloads. Returns for periods longer than 1 Year are annualised. The Equity and Global Equity Portfolios are segregated mandates run according to specific client income, risk and return objectives. Benchmark [1] = 100% All Share Index TR, Benchmark [2] = 100% MSCI World Index TR [GBP], Benchmark [3] = 50% JSE ALSI + 25% ALBI + 15% MSCI + 10% SA Cash TR, Benchmark [4] = 100% SA Cash Index + 2%. Benchmark [5] = CPI + 5% During the month of January, a couple of changes were instituted within the Cordatus Worldwide Flexible Fund. Namely, 5% of the portfolio was directed offshore to take advantage of price declines in developed markets (specifically the USA and Europe). This amount was funded primarily from SA cash and a lesser portion from the sale of SA shares we do not feel comfortable holding in a rising interest rate environment. We have not made the purchases as yet and cash exposure has risen as a result. Page 2 of 10 Cordatus Capital Monthly Investment View January 2014
Table 3: Asset Allocation of Cordatus Portfolios ending 31 January 2014 Manager CORDATUS CORDATUS CORDATUS CORDATUS CORDATUS CORDATUS Portfolio Global Equity SA Equity WW Flex Fund WW Flex FoF PWM Bal FoF PWM Inc FoF Currency GBP ZAR ZAR ZAR ZAR ZAR South Africa 0 96 41 67 73 87 Equity 0 86 40 45 45 4 Property 0 5 0 1 2 3 Bonds 0 0 0 7 14 43 Cash 0 5 1 12 12 37 Other 0 0 0 2 0 0 Offshore 100 4 59 33 27 13 Equity 91 4 49 27 24 5 Property 5 0 0 2 1 1 Bonds 0 0 0 1 1 3 Cash 4 0 10 1 1 4 Other 0 0 0 2 0 0 Clients concerned with income generation and or capital preservation are directed towards the PWM Income FoF that we manage on behalf of Prescient Wealth. It is instructive to review Fund performance as generating returns within fixed income asset classes over the past month has been challenging to say the least. So how have we fared? Generally, we avoided the worst of it by; Investing in fixed income managers who were; running low duration bond positions, had little or no domestic property exposure and availed themselves of offshore exposure where permitted. These managers have been using the rising bond yields to lengthen duration within the funds, locking in significantly higher yields for the year ahead. We at Cordatus continue with a position of 4% (SA) and 5% (Offshore) equity expecting that the current sell-off will abate in the near future. Performance of PWM Income FoF during January 2014 1 0.4 0-1 -2-3 -4-5 -0.1-1.2-2.4-3.2-4.0-6 -7-8 SA Cash PWM Income FoF SA Bonds (1-3yr) SA Equity SA Bonds SA ILB's -7.1 SA Property Page 3 of 10 Cordatus Capital Monthly Investment View January 2014
CHARTS & GRAPHS WE FIND INTERESTING AT THE MOMENT GRAPH 1: SA interest rates have been raised in response to ZAR weakness and actions by Central Bankers in a similar situation. CPI is expected to breach 6% towards the middle of 2014 before gradually declining. ZAR levels the wildcard. GRAPH 2: Globally, the cost of capital is rising. Are SA bond yields looking attractive as yet? Slow move to increase duration being undertaken by our underlying managers. Page 4 of 10 Cordatus Capital Monthly Investment View January 2014
GRAPH 3: The ZAR powers past R11/US$ for the first time since 2008. The ZAR is cheap, but is it cheap enough? Will current levels be sufficient to unwind the current account deficit? The headaches around the fiscal deficit are getting bigger as Government borrowing costs rise. GRAPH 4: Foreign capital inflows in 2012 were always a worry should the Fed begin tapering and/or SA fall out of favour (with or without other emerging markets). Looks like the chickens have come home to roost! Page 5 of 10 Cordatus Capital Monthly Investment View January 2014
GRAPH 5: Flows a problem within equities as well after the massive re-rating in Industrial stocks in 2013, coupled with capital flows. Being cognisant of the risk, return and investor profile of individual mandates, we would remind investors who have entrusted Cordatus with their long-term wealth management requirements that performance (see page 1) over the next decade is unlikely to match that of the past 10 years! The price you pay for any asset is important and our portfolios (as shown in Table 3) reflect our view on relative valuations, reversionary trades and the need for protection. Local cash levels have been raised slightly during the past quarter into domestic equity strength, reflecting our concerns around domestic valuations. WHAT YOU SHOULD KNOW ABOUT MEDICAL TAX CREDITS. Source: Ingé Lamprecht, 27 January 2014, Moneyweb Tax More changes to be introduced from 1 March. Over the past two years, the tax benefits individuals enjoy for medical aid contributions and expenses, have gradually changed from a deduction to a tax credit system. While the deductions for medical aid contributions have already been replaced with a medical credit system for most taxpayer categories, deductions for qualifying medical expenses will also be replaced with a credit system from March 1 this year. Page 6 of 10 Cordatus Capital Monthly Investment View January 2014
Wessel Smit, member of the South African Institute of Chartered Accountant's (Saica) national tax committee, explains that a tax credit reduces an individual's tax liability. This differs from a medical deduction, which lowers an individual's taxable income. A medical tax credit allows all taxpayers the same benefit in rand, whereas a medical tax deduction is more beneficial to a taxpayer with a marginal tax rate of 40% than someone who pays 18%, he says. The disadvantage is that if an individual's tax liability in a given tax year is not sufficient to utilise all the tax credits available, the benefit will be forfeited and not be carried over to the next year. Credit on medical fund contributions Tax credits on medical funds contributions were already introduced on March 1, 2012. Currently the credit is R242 per month for the main member and the first dependent and R162 per month for additional dependents, but it is likely to be adjusted for inflation from March 1, 2014, Smit says. While the credit system has been in use for taxpayers younger than 65 and taxpayers younger than 65 with a disability or a disabled dependent, it will be applicable to all taxpayers - including taxpayers 65 and older who contribute to a medical fund from March 1, 2014. Other medical expenses Up until the end of the current tax year (2014), taxpayers were entitled to a deduction for qualifying medical expenses (other than medical fund contributions) not recovered from the medical scheme. The deduction was determined using a specific formula in the Income Tax Act. From March 1, 2014, this deduction will also be replaced by a credit, which will be more favourable to taxpayers who are 65 years and older and taxpayers below age 65 who are disabled or who has a dependent with a disability. Smit says with regards to taxpayers younger than 65, the credit for medical expenses will be determined as follows. The medical tax credit for 12 months (with regards to medical aid contributions) will be multiplied by four and subtracted from the total medical aid contributions for the year. The qualifying medical expenses the taxpayer incurred during the year that exceeds 7,5% of the taxable income will be added to this amount. This total will be multiplied by 25% to derive at the tax credit for medical expenses. For taxpayers 65 years and older, or younger than 65 but with a disability or a disabled dependent, the benefit will be much more substantial. The medical tax credit for 12 months will be multiplied by three and subtracted from the total medical aid contributions for the year. All qualifying medical expenses will be added to this amount. This total will be multiplied by 33.3% to derive at the medical expenses credit. In terms of the Income Tax Act, qualifying medical expenses include services rendered and medicines supplied by registered medical practitioners, as well as specialists and homeopaths, Page 7 of 10 Cordatus Capital Monthly Investment View January 2014
hospitalisation in a registered hospital or nursing clinic, home nursing by a registered nurse, midwife or nursing assistant, prescribed medicines from a pharmacist and medical expenses incurred and paid outside South Africa. CAPITAL GAINS TAX: TRUSTS vs INDIVIDUALS Source: Rigard Sevenster, fiduciary specialist at Glacier by Sanlam, 05 December 2013 Most important differences highlighted. Many financial planners, and the general public at large, have expressed concern regarding when and to what extent they or their trust is liable for capital gains tax (CGT). Knowing the different tax treatments will assist in choosing how to structure your estate and trust more effectively. In this article we highlight some of the most important differences in CGT from either a trust or an individual's perspective. Tax rates at a glance As most people are aware, a normal trust is taxed on all taxable income at a fixed rate of 40%, whereas individuals earning above the threshold are taxed at their personal marginal rate, ranging between 18% to 40%, and qualify for certain exemptions and rebates. When a capital gain is realised within a trust, 66.6% of that gain has to be included for income tax purposes (taxed at 40% as stated), effectively meaning that a trust's CGT is 26.7%. A trust has no yearly exclusion. Individual taxpayers who make a capital gain will be able to exclude R30 000 of any gains in a year (or R300 000 in the year of death) and will include 33.3% of the remaining gain for income tax purposes. The gain will be taxed at their specific marginal rate (between 18% and 40%), which effectively means that an individual will have a maximum CGT rate of 13.3%. Without taking any other factors into consideration, one would therefore pay more than double the CGT in a family trust than if you held and sold the assets in your own name. Enter the conduit principle... Distributing the gains from the trust The "conduit principle" with regard to trusts has been written about extensively and is also at the centre of National Treasury's proposed changes to the taxation of trusts. In simple terms, income or gains that are realised inside a trust, can "flow through", or be distributed to the beneficiaries of the trust, while retaining the nature of the income. This means that dividends received get passed on as dividends and taxed as dividends, that interest earned and distributed gets taxed as interest, and that capital gains that are distributed get taxed as capital gains. These amounts are then taxed in the hands of the beneficiaries and not the trust. The fact that the nature of the income is also retained is very important, as natural persons receive certain exemptions, exclusions and/or rebates on certain items and get taxed differently. Page 8 of 10 Cordatus Capital Monthly Investment View January 2014
In terms of paragraph 80 of the Eighth Schedule of the Income Tax Act, where a capital gain is vested in a beneficiary of the trust, the trust will not have that gain included in its own tax calculation, but it will be taxed in the hands of the beneficiary. This means that where a trust deed authorises the trustees to do so, the trustees are able to distribute the capital gains of the trusts, vesting it in the beneficiaries. It is also possible to distribute the gains to multiple beneficiaries, each paying at their assumed lower marginal tax rate and each having their own annual exclusion of R30 000. Substantial capital gains tax savings can thereby be achieved. It is important to keep in mind that to achieve savings of this nature, the capital gain has to be allocated to a resident natural person in the year in which it was realised by the trust. Many trusts have beneficiaries that include another trust. If the gain passes to another trust first and then to an ultimate beneficiary of the second trust, the higher effective tax rate applies. Tax savings vs protection What is vital to remember, though, is that the main purpose of a trust should be the protection of trust assets and beneficiaries' interests, and any possible tax savings should receive only secondary consideration. If capital gains are vested in a beneficiary, the protection that the trust offers on the portion that is vested falls away. If the gain is distributed, there might be a temporary tax saving, but if the gain vests in the beneficiary, it becomes an asset in his or her estate and is open for attachment by creditors and ex-spouses, as well as increasing the estate value for estate duty purposes. Trustees should therefore consider all the implications before taking this route merely to potentially save on CGT. Other CGT considerations Many people with family trusts received advice years ago to transfer their family homes into their trust. This was done at a time when trusts were slightly more tax efficient than they are today and before SARS started removing any tax advantages that trusts might have had. One of the consequences of SARS's current treatment of trusts is the exclusion of the primary residence rebate. An individual who sells his primary residence does not have to include the first R2 million of any gain made, but only if it meets the requirements set out - one of these being that the property had to be registered in the individual's name. Having your primary residence inside a trust will mean that any gain made on the sale will have to have all of it included or distributed. Changes to the law? During this year's budget speech, the Minister of Finance managed to alarm a number of people when it was indicated that government was looking at various changes to tax law regarding trusts to prevent what they perceived as tax avoidance. After various meetings with the financial planning industry and regulatory bodies, including the Fiduciary Institute of Southern Africa (FISA), the Financial Planning Institute (FPI) and the Law Society of South Africa, it was explained what the general benefits of having a trust are, and highlighted that less individuals than believed used trusts in a manner to save on capital gains tax. Treasury has not finalised any tax changes and indicated these were not likely to happen in the short term. Page 9 of 10 Cordatus Capital Monthly Investment View January 2014
Keeping the status quo As things stand, the taxation of trusts is unchanged and will remain that way for the foreseeable future. Trustees are still able to let income flow through to beneficiaries, thereby reducing the trust's tax liability. It is important to remember that trustees may only distribute capital gains to beneficiaries if the trust deed empowers them to do so. It is therefore vital to consult an adviser in order to get the right structure and advice. Regards, The Cordatus Team Craig, Rolfe, Kim and Arthur DISCLAIMER Cordatus Capital (Pty) Ltd is an authorised Financial Services Provider [FSP # 21263]. The content of this presentation and any information provided may be of a general nature and may not be based on any analysis of the investment objectives, financial situation or particular needs of the client (as defined in the Financial Advisory Intermediary Services Act). As a result, there may be limitations as to the appropriateness of any information given. It is therefore recommended that the client first obtain the appropriate legal, tax, investment or other professional advice and formulate an appropriate investment strategy that would suit the risk profile of the client prior to acting upon such information and to consider whether any recommendation is appropriate considering the client s own objectives and particular needs. Any opinions, statements and any information made, whether written, oral or implied are expressed in good faith. The products discussed in this presentation, may or may not, be regulated by the FSB. Page 10 of 10 Cordatus Capital Monthly Investment View January 2014