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9 Key Themes Impacting Stock Returns 

Scott Migliori 

Fourth-Quarter Outlook  


Scott Migliori, CIO Equity US, says 2013 bond losses may convince investors that a secular low in bond yields is behind us, prompting a shift to equities in an effort to hit their return targets. The S&P 500 is still attractive at 14 to 15 times earnings.
Effect on Stock Market Returns
Corporate Profits
2013 S&P 500 earnings growth should achieve a 5-7% growth rate to ~ $107 after posting a 3.5% YoY rate through Q1 2013. Profit margins held up despite meager sales growth, and labor productivity is reaccelerating, slowing unit labor cost increases. Share buybacks and industry consolidation should help boost earnings per share. 2014 earnings growth of 8-10% YoY is likely with less of a US fiscal drag, a slow but steady recovery in the eurozone, continued reflation in Japan, and some improvement in emerging markets economies.

Headline inflation should remain well behaved in 2013 and is likely to end the year near 1.5-1.75%. Final demand growth is still subpar, which is making it difficult for companies to achieve better pricing power without sacrificing revenue growth. Dollar appreciation and slower growth in emerging markets has left little in the way of import inflation. Energy price pressures cannot be ruled out given political instability in the Middle East, but this would likely weaken spending on discretionary items. A 1.75-2% headline CPI in 2014 is likely with core inflation still below 2%.

Interest Rates
The back up in interest rates on the prospect of tapering was sufficient, along with slow growth indications through the summer, for the Fed to postpone tapering. While the unemployment rate has been declining, there are questions about the low labor force participation rate and the quality of job growth. Meanwhile, inflation remains below the 2% target, with core inflation measures the lowest since 2008. Tapering is more likely in Q1 2014, and if we are correct about stronger growth prospects, the 10 year US Treasury yield could rise to 3.25% in 2014.

Economic Activity
Real GDP growth closer to 1.75-2% is likely in 2013, with prospects of an acceleration to 2.5% in 2014. Consumer spending remains cautious despite gains in home and equity prices, but we should see more full time jobs in what will be the sixth year of economic expansion. Housing starts have recovered but are still only back to prior recession levels. Replacement demand for capital goods should pick up, and ISM new orders have been strong. Export growth prospect look stronger in 2014 with the UK, eurozone, Japan, and China all showing signs of mild reaccelerations. The fiscal drag should ease by slightly less than 1% of GDP. Best guess is Federal government shutdown will converge with debt limit debate with mid-October Resolution. GDP downside is to reduce 4Q growth by 0.5% with an increase of that amount in 1Q2014.

Eurozone PMI, business confidence, and consumer confidence indexes have returned to growth territory, with inventory replenishment likely to lead to stronger final demand later in 2013. With less fiscal drag in 2014, real GDP growth of 1-1.25% is within reach. Japan’s reflationary policies are working, and a planned consumption tax hike in 2014 is likely to be offset by investment tax cuts and monetary ease if necessary. China’s production and export results have been improving, and emerging markets should benefit from currency depreciations.

Relatively stronger growth prospects in the US, as well as better capitalized banks, should favor the US dollar over other developed market currencies. The Fed’s broad trade weighted dollar appreciated less than 4% through September, and we would expect gains limited to 5-7% in 2014 as fixed income yields are likely to drift up sooner in the US than in other DM economies. Further improvement in the current account deficit from 2.5% of GDP to just below 2% of GDO is likely in 2014 as foreign growth picks up and shale oil production advances. Stronger merger and acquisition deal activity in the US may also attract foreign capital inflows.

Assuming our earnings expectations are correct, the forward P/E multiple on the S&P 500 is still attractive in the 14-15 times range. Relative yields still favor equities over all but high yield bonds. Share repurchase activity has been very strong and will likely remain robust, which should further support equity valuations. With large corporate cash holdings and improving management confidence, merger and acquisition activity is ramping higher, and we may see higher takeover premiums entering valuations. 2013 losses in bond portfolios may lead more investors to conclude the secular low in yields is behind us, and portfolio preferences may shift toward equities in order to reach target returns.

Equity mutual fund inflows have been mild year to date, but may pick up as investors respond to losses on bond exposures. With nominal and real yields still fairly low on fixed income instruments, and commodities still not regaining much strength, investors have few other choices besides equities to achieve their required returns. Equity corrections approaching 5% have been consistently met with renewed buying.

Fiscal Policy
Improvement in the budget from the tax revenue side has been better than expected year to date, with the federal deficit likely to be cut in half from its 2009 level of 10% of GDP. Nevertheless, a showdown on the debt ceiling is pending, with little indication either side is prepared to compromise. Public tolerance for a government shutdown may be limited, forcing a deal, although the President is facing low voter approval levels. If our GDP growth expectations are achieved in 2014, a fiscal deficit below 4% of GDP is possible.

The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

A Word About Risk: Investing involves risk and you can lose money. Equities have tended to be volatile and, unlike bonds, do not offer a fixed rate of return. Dividend-paying stocks are not guaranteed to continue to pay dividends. High-yield or “junk” bonds have lower credit ratings and involve a greater risk to principal. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets. US government bonds and Treasury bills are guaranteed by the US government and, if held to maturity, offer a fixed rate of return and fixed principal value. Bond prices will normally decline as interest rates rise.
The Standard & Poor's 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the U.S. stock market.

Gross domestic product (GDP) is the value of all final goods and services produced in a specific country. It is the broadest measure of economic activity and the principal indicator of economic performance.

Price to earnings (P/E) is a ratio of security price to earnings per share. Typically, an undervalued security is characterized by a low P/E ratio, while an overvalued security is characterized by a high P/E ratio.


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