BMO Capital Markets’ Brian Belski published his 2013 Market Outlook yesterday.We already know that he expects the S&P 500 to end 2013 at 1,575.
But this new 39-page report offers more colour to his call. Here are some key points:
- Multiple expansion will define next phase of investing, as opposed to multiple contraction
- The investment cycle favours US stocks over bonds, high quality over low quality, and fundamental investing relative to macro investing
- As a result, risk premiums are likely to fall
- Earnings growth below historical averages, but will be of higher quality and more consistent
- EPS forecasts for year end 2013: $106.25
- Domestic recovery will help offset volatility from other regions in the world
Belski acknowledges that 2013 will be a year of low earnings growth. “Admittedly, we are forecasting relatively low rates of earnings growth for 2013 given our price forecasts,” he writes. “Our reasoning is that the productivity well has all but run dry and current peak profit margins are set to decline, putting some downward pressure on earnings growth unless global demand picks up again.”
But this doesn’t mean profit margins will implode from record levels. Indeed, Belski believes the opposite, which is why he favours U.S. stocks for the long-run:
Stability and quality of earnings will enhance fundamental believability. A main reason we believe US stocks will outperform over the next few years is the significant and positive structural change that most US companies have successfully demonstrated over the past decade or so. While many investors focused on higher growth emerging market regions around the world and asset classes like commodities, a vast majority of US companies took advantage of declining and record low interest rates to shore up balance sheets and focus on cash flow generation. In addition, many of these same companies increased their productivity by minimising cost structures. One result has been a dramatic improvement in profit margins, which are currently at peak levels (Exhibit 10, top).
Although we agree that peak margin levels are unsustainable, we do not expect any sort of significant drop from current levels. Based on our work, secular shifts in profit margins tend to last for decades, which makes sense because structural changes in the economy typically have a long-lasting impact on profitability. In addition, the tax and interest rate environments remain favourable. For instance, taxes paid as a percentage of total profits have fallen significantly (Exhibit 10, bottom), which likely reflects the fact that a higher share of revenue (and profits) is being generated from international markets where tax rates are lower. Furthermore, any corporate tax reform within the US is likely to set rates lower given that the US maintains one of the highest corporate tax rates in the world. Finally, the combination of lower leverage and interest rates has greatly reduced the interest rate burden of companies. True, interest rates are not likely to remain historically low forever, but they are not likely to rise significantly anytime soon.
Deutsche Bank’s David Bianco made this same argument for profit margins earlier this year.
Here’s the chart from Belski’s report:
Photo: BMO Capital Markets