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The environment of financial repression provided companies with the perfect tailwind to pursue buybacks that boost both EPS and shareholder returns. However, it appears that this secular driver has peaked and is losing momentum.

US buybacks (ex financials) reached a peak in Q3 2022 but have been in decline since

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Chart 1: US (ex financials) quarterly and rolling 4Q buybacks (USD, Bn)

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US buybacks (ex Financials) peaked at trailing 4-quarter rate of $1tn in Q3 last year and have eased back since. The opportunity to repurchase shares on a large scale has been rational behaviour for companies in the post-GFC landscape of extremely cheap money and rising free cashflow. However, with interest rates rising and profits declining, there will now surely be big question marks over companies' willingness to sustain buybacks at these levels.

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With technology buybacks declining where will the new leadership come from?

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Chart 2: US technology companies have been the dominant force behind US buybacks

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Chart 2 shows the US sector buybacks as a percentage of total (ex financials) buybacks, demonstrating the dominance of the technology sector. Over the past decade technology has seen its share of buybacks rise from 20% to a peak of over 50% in mid-2021. The share of the next four biggest sectors has largely remained flat and range bound. With technology buybacks now in decline, there will be big question marks over which sectors, if any, will pick up the baton.

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A US buyback adjusted yield is almost 3x higher than the cash dividend yield

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Chart 3: Comparing the US dividend yield with the buyback-adjusted yield

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Chart 3 shows the impact on the effective yield returned to shareholders when buybacks are included. The buyback-adjusted yield rises to 4.3% (versus a 1.6% dividend yield). Compression in the adjusted yield will impact long term return projections.

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^{Source: Wilshire and FactSet. Data as of March 13, 2023}

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The collapse of Silicon Valley Bank (SVB) and fears of contagion have hit global bank stocks, rippling through to wider risk off market sentiment. Recent events could well be the first of many unintended consequences of a rapid shift from ultra-accommodative to restrictive financial conditions.

A flight to safety in response to the SVB collapse

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Chart 1: Asset class returns since 7th March (SVB news)

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Declines in global bank stocks and contagion concerns have rattled equity markets and economically sensitive assets such as oil since the news on SVB broke. This has also led to a flight to perceived safe-haven assets such as gold.

What started with US regional banks rapidly became global

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Chart 2: Regional bank sector returns since the SVB news

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The collapse of SVB was initially seen as isolated to the US with the US banking sector experiencing the worst of the sell-off in the few days that followed the SVB news. Contagion fears soon led to a sell-off in banks globally, with particular concern over the value of bond portfolios held by many institutions. In recent days the focus has shifted on to European banks, with the spotlight on Credit Suisse which saw its shares plunge by a quarter on the 15th March. As Chart 2 shows Asian banks, which are seen as relatively well capitalised have held up well and only seen modest declines.

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Year end 2023 US market interest rate expectations plunge by 170bps

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Chart 3: Contagion fears in the banking system have led to a dramatic decline in US year end 2023 rate expectations

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The upshot of recent events has been the significant decline in US interest rate expectations. Markets had been ramping up rate expectations on the back of a sequence of strong economic data, pricing in a 50bps hike from the Fed at its March meeting. As the chart 3 shows, following recent events in the banking sector markets now expected the Fed to halt its tightening cycle, and are now in fact forecasting around 75bps of rate cuts by the end of the year to 3.9%.

Ultimately, the sharp fall in rate expectations could be an overreaction if the contagion proves to be limited. However recent events have created yet another conundrum for the Fed. SVB could be the first of many casualties to emerge as restrictive financial conditions start to take their toll.

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^{Source: Wilshire, Refinitiv and Federal Reserve. Data as of March 15, 2023}

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Having rallied in January on optimism that a recession would be avoided, the release of surprisingly strong labor market data forced the market to reappraise the trajectory of interest rates (dispelling any notion of them nudging lower later this year).This generated a cautious risk off tone that pushed the FT Wilshire 5000 -2.4% lower in February. However, the index is still up 4.4% YTD.

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Exhibit 1: Risk aversion came to the fore in February driven by a rise in market interest rate forecasts

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^{Source: Wilshire. Data as of February 28, 2023.}

… the drawdown had a different dynamic compared to other recent pull backs. Here are 4 examples:

1 - Despite market weakness the technology sector leadership persisted

A key feature to the 2022 drawdown was the persistency of the decline in technology stocks. Interestingly, the February risk off move saw the technology sector outperform, delivering a positive sector weighted contribution to return (see Exhibit 2). In fact, year to date the technology and digital information and sectors have been the dominant positive contributions to aggregate returns. This is a mirror opposite to the 2022 dynamic.

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Exhibit 2 : Sector weighted contributions to aggregate returns - YTD and February 2023

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^{Source: Wilshire. Data as of February 28, 2023.}

2 - The rotation to the Growth style (v Value) also persisted in February.

The positive inflection in the performance of the FT Wilshire Large Cap Growth index relative to Value that started in January persisted in February. This is a reversal of the 2022 dynamic (Exhibit 3). This rotation has occurred despite the rise in bond yields and real yields in February - these were key drags on highly valued Growth stocks in 2022.

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Exhibit 3: Growth v Value style performance continues to inflect higher.

^{Source: Wilshire. Data as of February 28, 2023.}

3 - A change in market dispersion dynamics in 2023 - the shift back to the dominance of the few.

Exhibit 4 compares the performance of the top 10 stocks in the FT Wilshire 5000 to the performance of the median stock to gauge the degree of performance dispersion. 2022 saw the median stock outperform the top 10 stocks implying a widening of dispersion. However, 2022 year-to-date has seen the opposite occur with the top 10 stocks significantly outperforming the median stock. This narrowing of dispersion has marked the return to the dominance of the few that characterized the market prior to 2022.

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Exhibit 4: Comparing the return generated by the top 10 stocks v the median stock

^{Source: Wilshire. Data as of February 28, 2023.}

4 - The 2023 YTD returns have been driven by a PE expansion - the opposite pattern to 2022

Exhibit 5 decomposes market returns drivers into the contribution from changes to dividends, changes to EPS forecasts and changes to valuation. In the case of the US market, over the last 12 months the negative return was mainly attributable to the significant decline in PE valuation (grey bar). In 2023 the opposite has occurred with the positive return been driven by the expansion in the PE multiple.

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Exhibit 5: The decomposition of market returns - 12months and YTD

^{Source: Refinitiv. Data as of February 28, 2023.}

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The improvement in risk appetite in recent months has been underpinned by a 'Goldilocks' scenario of easing financial conditions, the prospect of a soft landing for the US economy and the expectation that US interest rates are close to peak levels. However, this may have all come too soon.

Markets have been caught off guard by a recent strong bout of economic data

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Chart 1: Have we now have hit a nadir in economic data?  

^{Source: Wilshire, Refinitiv and Factset. Data as of February 8th, 2023}

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The last few weeks have witnessed a succession of strong data releases. As Chart 1 shows this includes a sizeable rebound in the US ISM services index and the well-above expectation January non-farm payroll figures. The latter further confirming the resilience of the US labour market. Chinese PMIs have also inflected higher following the reopening of the economy post-Covid. Further signs of improving activity in the world's second largest economy will likely prove a boost to growth globally.

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Reassessment of US market interest rate expectations on the back of stronger economic data  

Chart 2: We have seen a sharp rise in US market interest rate expectations in recent weeks

^{Source: Wilshire, Refinitiv and Factset. Data as of February 8th, 2023}

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Chart 2 shows the latest US market interest rate curve out to the end of 2023 versus the curve at the end of January, before the release of the stellar non-farm payroll figures. The red line shows the Fed's current interest rate projections. As we can see, the recent sequence strong set of data has fed through to a marked rise in US market interest rate expectations. Markets now see rates peaking later at 5.25% in September (up from 4.9%) and the degree to which rates are expected to fall back has also eased significantly. Are markets now beginning to agree with the Fed's view that rates may have to stay higher for longer?

Shift in 12 month forward PE the main driver behind the 'Goldilocks' market rally

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Chart 3: Total return decomposition shows PE re-rating as the key driver of returns-both on the way up and on the way down

^{Source: Wilshire, Refinitiv and Factset. Data as of February 8th, 2023}

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Chart 3 shows the total return decomposition for the US, UK and Europe ex UK, breaking the returns down by dividend and shifts in EPS and PE. We can see that last year's declines to the lows in October were driven by the PE de-rating, with EPS actually rising in the US and UK. Contrast this with the returns from the October lows to date and we can see a reversal of the 2022 profile, with a PE re-rating the main driver, while EPS in all three regions have declined.

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Analyst's US EPS estimates continue to move lower despite a backdrop of improving risk appetite in markets

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Chart 4: US 2023 and 2024 EPS estimates have seen further downgrades since the market low in October  

^{Source: Wilshire, Refinitiv and Factset. Data as of February 8th, 2023}

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Drilling further into the status of US EPS, a constant theme throughout the Goldilocks rally has been further downgrades to US EPS estimates. Chart 4 shows the progression of 2023 and 2024 EPS estimates since the start of last year. As the chart highlights, the market rally from the low in October has coincided with further downward revisions to analyst's EPS estimates, more pronounced in the 2023 numbers which have declined -7.5%. This has further magnified the (low quality) US 12-month forward PE re-rating we've seen since October we highlighted in Chart 3.

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Anticipation of a pivot in the degree of Fed hawkishness was the catalyst behind the recovery in risk appetite that commenced in mid-October last year. This positive momentum continued in January producing a return of 6.9% for the FT Wilshire 5000 for the month. From the mid-October low, the FT Wilshire 5000 had appreciated 14.5% to the end of January.

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Exhibit 1: The risk rally that started in mid-October last year continued into January

^{Source: Wilshire. Data as of January 31, 2023.}

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However, the rally can be dissected into two distinct phases

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Exhibit 2 breaks the rally in the FT Wilshire 5000 since mid-October into two phases (October to December versus January). In the first phase, the rally was still defensive in nature represented by the marked outperformance of the Value style. By contrast, January saw a similar return for the market but this time it was driven by the outperformance of the Growth style.

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Exhibit 2: A rotation to the Growth Style in January

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^{Source: Wilshire. Data as of January 31, 2023.}

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The decline in real yields has contributed to the rally in the Growth style

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Exhibit 3 shows relative performance of the FT Wilshire large Cap Growth versus Value and the US 10yr TIP real yield inverted. Style rotation responds to inflections in the real yield. The decline in the real yield in January has contributed to the Growth style outperforming the Value style by 5.7%  

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Exhibit 3: Growth style outperformed in January helped by falling real yields

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^{Source: Wilshire, Refinitiv. Data as of January 31, 2023.}

Growth benefitted from the contribution from 4 sectors in January

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Exhibit 4 compares the sector weighted contributions to the returns for the Growth and Value style indexes in January. Growth benefitted significantly  from the larger respective contributions generated by four sectors - Digital Information, Technology, Consumer Goods and Transportation. These tend to be seen as long duration growth sectors that respond positively to declining real yields.

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Exhibit 4: Comparing the sector weighted contributions for Growth and Value

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^{Source: Wilshire Data as of January 31, 2023.}

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The Fed remains more skeptical and awaits evidence of services inflation turning a corner.

Asset performance since mid-October reflects growing confidence about the inflation outlook.

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Chart 1 shows the returns accrued by the FT Wilshire 5000, US bonds and the US dollar from the low point reached on October 14th last year and performance YTD for 2023. While both equities and bonds have rallied strongly the dollar has fallen sharply. The common denominator between these divergent moves is growing conviction that US inflation has already peaked and that US interest rates will follow suit.

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Chart 1: Move in US assets since October 14th low and YTD

^{Source: Wilshire, Refinitiv, FactSet. Data as of January 17, 2023}

Key inflation gauges seem to have peaked several months ago

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Chart 2 plots the key US inflation indicators and shows a profile of inflation peaking (and subsequently declining) over the last six months. In fact the Fed's key indicator the Core PCE deflator peaked in February 2022. It also appears that the Fed ramped up its hawkishness as evidence of the peak started to appear.

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Chart 2: Key US inflation gauges appear to have peaked several months ago

^{Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023}

However, the Fed is probably waiting for evidence of services inflation to peak

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Chart 3 shows that the key driver behind the peak in inflation has been the rapidity of the decline in both goods inflation and input prices as measured by the PPI indicator. Services inflation has yet to peak, and the Fed will probably need to see this confirmed in subsequent data to change tack on interest rates.

Chart 3: Declining goods inflation but services inflation (the Fed's focus) remains elevated.

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^{Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023}

A gap between market and the Fed's interest rate curve forecasts - fade vs higher for longer

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Chart 4 plots both the markets interest rate and Federal reserve dot plot curve forecasts. The market expects rates to peak close to 5% in Q2 but then to 'fade' lower into the second half of the year as growth headwinds and disinflationary pressures push rates lower. However, Fed forecasts paint a picture of continued increases throughout the course of the year reaching peak rate by the end of the year (higher for longer).

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Chart 4: Mind the gap between the market and Fed interest rate forecasts

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^{Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023}

The Fed has started to 'taper' its hawkishness - impacting the dollar

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While the Fed is still waiting for more evidence of inflation peaking it has been concerned that the deliver of restrictive financial conditions runs the risk of slowing the economy too aggressively and has subsequently started to rein in (taper) the scale of interest rate increases it is delivering at the FOMC meetings (see Chart 5). Tapering has been a contributory factor behind the weakening of the dollar.

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Chart 5: The Fed is tapering the magnitude of rate hikes - impacting the dollar

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^{Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023}

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Read more in our latest Market Driver Insights report.

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The almost 6% decline in December resulted in the FT Wilshire 5000 registering a decline of -19% for 2022. This constitutes the fourth largest annual drawdown since the inception of the index in 1970.

Markets and risk aversion responded to a perfect storm of war (Ukraine), inflation, real income and supply chain shocks and a rapid rotation to restrictive financial conditions just as economies were recovering from the COVID impact - all making 2022 an annus horribilis.

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Exhibit 1: Largest Calendar year drawdowns for the FT Wilshire 5000

^{Source: Wilshire and Refinitiv. Data as of December 31. 2022}

A lack of diversification opportunities

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What made 2022 particularly difficult was the lack of diversification opportunities. For example, Exhibit 2 shows that 2022 was the first time in 40 years that both bonds and equities delivered simultaneous negative returns.

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Exhibit 2: Simultaneous decline in US equity and bond returns

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^{Source: Wilshire and Refinitiv. Data as of December 31. 2022}

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Two sectors contributed almost half of the aggregate decline in US equities

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Exhibit 3 shows the ranked FT Wilshire 5000 sector-weighted performance contributions for 2022. Almost half of the aggregate decline in the FT Wilshire 5000 is accounted for by the scale of negative contributions delivered by the Digital Information and Technology sectors.

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Exhibit 3: Sector weighted contributions for the FT Wilshire 5000 in 2022

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^{Source: Wilshire. Data as of December 31, 2022}

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The other key market dynamic was the rotation away from Growth towards Value style

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Exhibit 4 depicts the -25.1% underperformance of the Growth style relative to Value in 2022. This has effectively unwound the rotation to Growth that occurred during the immediate aftermath of the COVID pandemic.

An important driver of underperformance of the Growth style was the negative valuation impact of rising real yields in 2022.

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Exhibit 4: Growth Style performance relative to Value Style

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^{Source: Wilshire. Data as of December 31. 2022}

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Exhibit 5 examines the sector-weighted contributions for both the Growth and Value style indices. Value benefitted from a larger positive contribution from the energy sector compared to the Growth Style. It also benefitted from not incurring the scale of negative contributions in the digital information, technology, and consumer goods sectors.

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Exhibit 5: Comparing the sector weighted contributions for the Growth and Value Style indices

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^{Source: Wilshire. Data as of December 31. 2022}‍

2022 saw an improvement in performance dispersion

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Comparing the performance of the top 10 stocks by market cap (equally weighted) to the performance of the median stock in the FT Wilshire 5000 index is a useful gauge of performance dispersion. Exhibit 6 shows the scale of reversal in dispersion from 2021 to 2022. In 2021, median stock performance significantly lagged the return delivered by the top 10 stocks (negative dispersion). 2022 saw the median stock outperform delivering an improvement in dispersion characteristics.

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Exhibit 6:  Comparing the performance of the top 10 stocks to the median stock

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^{Source: Wilshire. Data as of December 31. 2022}

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Despite persistent fears that financial conditions are sufficiently restrictive to cause a slowdown next year, the positive market reaction to the weaker than expected October CPI data seemed to indicate a transition to a new phase of inflation dynamic analysis - the likelihood of the delivery of sustained disinflation in 2023.

Bad economic news feeds this narrative and therefore could now be seen as good news.

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Chart 1: On the cusp of phase 3 of inflation analysis

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 ^{Source: Wilshire, Refinitiv. Data as of November 15, 2022}

‍Intensified focus on the Fed’s disinflation forecast for 2023

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Chart 1 plots the progression of the Fed’s core PCE inflation indicator. The twelve month period between February 2021 and February 2022 saw the inflation rate almost triple, generating the hawkish tilt by the Fed. Since then, the inflation rate has plateaued (albeit at an elevated level).

The focus now turns to the plausibility of inflation moving sequentially lower next year as predicted by the Fed. Their current forecast of year-end 2023 inflation reaching 3.1% requires a monthly run rate of 0.3%. A run rate of 0.2% a month would deliver a 2.4%-year end inflation level.

Forward looking indicators such as the ISM prices paid index point to continued downward pressure on headline inflation in the coming months.

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‍Chart2:  The ISM manufacturing prices paid index points to lower US CPI  

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 ^{Source: Wilshire, Refinitiv. Data as of November 15, 2022}

Perception that inflation could be peaking and then encountering disinflationary headwinds (after the October CPI report) produced a downward shift in the US interest rate curve as can be seen in Chart 3.

Any further signs of weakness in final demand (bad news) could now be the catalyst for continued downward shifts in the interest rate curve (good news).

Chart 3: US market rate expectations fell after the lower-than-expected US CPI numbers

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As can be seen in Chart 1, the second half of 2023 has seen the 2023 EPS growth rate forecast start to decline. This has clearly been connected to the rapidity of the commensurate decline in forward looking GDP growth forecasts.

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Chart 1: 2023 EPS growth forecasts have followed GDP forecasts lower

^{Source: Wilshire and FactSet. Data as of November 15, 2022}

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‍Technology and Health Sectors have been the key drivers behind the downgrading

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Chart 2 shows the sector weighted contribution to the aggregate 2023 market EPS growth rate. In May the forecast was for 12% EPS growth, and this has now declined to 7.9%. The main contributors to this 4.1% decline were the negative contributions from the tech and health sectors.

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Chart 2: Comparing the US vs World ex US PE ratio moves over the last 20 years

^{Source: Wilshire and FactSet. Data as of November 15, 2022}

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There is a lot of seasonality built into the 2023 EPS projections

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Chart 3 shows the progression of quarterly US EPS forecasts out to the end of 2023, with the blue bars showing the Q/Q growth rates and the grey line showing the quarterly forecast EPS (USD). As the chart shows, there is high levels of seasonality forecast over the next 12 months or so.

After flat or negative EPS growth expected for the next three quarters, a lot appears to be hinging on a recovery in EPS in Q3 and Q4 of next year.

Chart 3: A lot is riding on the delivery of a positive EPS inflection in Q3 2023

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^{Source: Wilshire and FactSet. Data as of November 15, 2022}

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