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A key feature of 2022 has been the sustained strength of the US dollar
2022 has seen persistent strength in the US dollar aided by positive interest rate differentials, haven status and the perception the US is less exposed to the Ukraine invasion energy shock. Exhibit 1 shows the long-term performance of the DXY dollar index and the 16.8% YTD return has pushed the dollar back to levels not seen since the turn of the century.
Exhibit 1: The dollar is back to levels last seen over 20 years ago
FX swings can have a large impact on unhedged regional equity returns depending on the location of investors. Due to GBP, Euro and JPY weakness, investors in the UK, Europe and Japan have a very different perception of regional market returns based in GBP, Euro and JPY versus the returns seen by a US dollar-based investor over both Q3 and YTD periods. For instance, it can be seen in exhibit 2 that UK unhedged investors (courtesy of the 8.2% decline in the pound) saw a positive return from US equities in Q3.
Exhibit 2: Comparing UK and US (unhedged) equity return profiles for Q3
Most commodity prices are denominated in dollars. Consequently, when the dollar appreciates it offsets the impact of any fall in prices to non - US dollar-based participants (and vice versa). For instance, exhibit 3 shows that although the oil price declined 22% in Q3 in dollar terms, due to the depreciation of sterling, euro, and the yen against the dollar the oil price drop denominated in those currencies is more muted. The distortion of the move in the dollar on the regional oil price is even more extreme looking at two-year data.
Exhibit 3: The impact of the dollar on regional oil price moves
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After a period of relative stability, we are starting to see a deterioration in the EPS or profit cycle through the prism of estimate trail analysis
Chart 1 shows the status of regional consensus EPS growth forecasts for this year and next and the revisions (deltas) to the forecasts over the last month. The notable negative revisions have been in Asia Pacific and Emerging Markets. In terms of 2023 growth rate projections, the US is still predicted to deliver the highest growth rate among developed markets.
Chart 1: Regional consensus EPS growth forecasts
Growth rate analysis does not provide insight into the status of the cycle as it simply measures the difference in EPS forecasts over two distinct time periods. If both periods see EPS decline by 10%, the growth rate remains the same. That is why EPS cycle analysis must be viewed via EPS trails that map the changes to calendar year forecasts over time. Chart 2 shows the EPS trails for the US and that after a period of stability both 2022 and 2023 EPS estimates have started to decline. The cycle seems to be deteriorating.
Chart 2: US consensus EPS trails - starting to wobble
Chart 3 shows revisions to 2022 and 2023 EPS estimates versus the August market high for both the US and World ex US at a sector level. Energy remains the only sector to see positive revisions to 2022 and 2023 estimates for the US and World ex US.
Chart 3: A broad deterioration in sector EPS revisions
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Markets have been gripped by risk aversion since mid-August
Markets have been gripped by risk aversion since mid-August in response to hawkish Fed and global central bank guidance, elevated inflation, and a significant tightening in financial conditions.
Chart 1 shows the status of regional market interest rate forecasts for 2022 and 2023 as well as the respective central bank forecasts. It can be seen that except for Japan, all other regions have witnessed significant uplifts to interest rate curves over the last three months.
Chart 1: Regional consensus and central bank 2022 and 2023 interest rate forecasts
Both the Fed dot plots and market interest forecasts have risen by 100 basis points. While the Fed forecasts point to a continued gradual increase in rates, peaking at 4.6% by the end of 2023, the market is predicting a gradual decline in rates over the course of the second half of next year.
Chart 2: US market consensus and Fed dot plot interest curves
Our Financial Conditions Indicator (FCI) is designed to reflect the impact on market risk appetite through the combined impact of related financial components. Since mid-August, the US FCI has increased and is in restrictive territory (a key driver of risk aversion). Some of the key elements pushing the FCI higher have been the rise in the USD (REER), interest rate forecasts, government and corporate bond yields and a contraction in real M2 money supply growth.
Chart 3: US financial conditions being driven higher on many fronts
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Hawkish Fed guidance sends FT Wilshire 5000 into reverse gear in August
August witnessed a significant reversal in risk appetite mid-month in response to a succession of hawkish Fed guidance. This bought an end to the +18.6% two-month rally that started on June 16 and peaked on Aug. 16. Since the mid-month peak, the FT Wilshire has declined -8.1%, producing a -3.8% move for the month of August.
Exhibit 1: August brought an end to the two-month rally
The mid-August reversal also produced a rotation in style performance. The table below shows that most of the underperformance of large cap relative to small cap in August was attributable to the larger negative contributions from the financials, digital info and services, health care and technology sectors.
Exhibit 2: Four sector-weighted contributions account for small cap outperformance
Rising bond yields impacted the highly valued long duration growth stocks in August and this resulted in the growth style (with its large exposure to the technology and digital information sectors) losing momentum relative to value as the month progressed.
Exhibit 3: Two sector weighted contributions account for growth underperformance
Exhibit 4 puts the growth vs value rotation into a longer perspective. Despite the scale of value outperformance so far this year, the relative trade still has a long way to go in order for it to mean revert back to 2016/17 levels (parity levels).
Exhibit 4: The long term perspective on Growth v Value relative performance
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Equities are a long duration asset class and returns should be viewed via the prism of long-time horizons
Although recent volatility and inflation angst have produced negative nominal and real returns for the FT Wilshire 5000 over the last 12 months, it is worth remembering that equities are a long duration asset class and returns should be viewed via the prism of long-time horizons.
The chart and table below show the progression of FT Wilshire returns over the last 20 years. Real annualized returns have exceeded 7% over the five-,10- and 20-year periods.
Exhibit 1: The aggregate and annualized nominal and real total returns for the FT Wilshire 5000
In Exhibit 2, over a 20-year period small cap's annualized returns of 10.8% have exceeded the 9.8% delivered from large cap. However, small cap's annualized returns have lagged large cap returns over three-, five- and 10-year time frames.
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US consumer durables, technology and retail have led the re-rating of the US market since mid-June
After a significant PE de-rating in the first half of the year and a narrowing of valuation dispersion, US consumer durables, technology and retail have led the re-rating of the US market since mid-June.
Chart 1 shows the current regional 12m forward PEs, the scale of the de-rating from the start of the year to the lows in mid June and the re-rating since. Following a 30% decline in the PE from 22.5 to 15.7x in mid-June, the US has been among those to see the biggest re-ratings since, along with Emerging Markets and Europe ex UK.
Chart 1: Scale of regional PE de-ratings in the first half of the year and the recovery since mid-June
Looking into what has driven the US re-rating, Chart 2 again shows the latest 12m forward PEs and the shifts in valuations at the US sector level. As we can see, the consumer durables, retail and technology sectors have seen the largest re-ratings since mid June. These sectors saw some of the largest de-ratings in the first half of the year.
Chart 2: Status of US sector 12m forward PE and the journey traveled so far in 2022
Drilling further into the dynamics within the US market, Chart 3 looks at the top quintile PE relative to the median stock PE. As we can see, the cluster of top quintile PEs has witnessed a significant relative PE expansion since mid-2017. The upshot of the market sell-off in the first half of the year, which had an outsized impact on more highly valued growth and tech stocks, is that we have seen a narrowing in the valuation dispersion between the top quintile and median stock PEs in the US, with the premium falling back toward pre-COVID levels in June. However, with the growth and tech sectors regaining market leadership since the US recovery, more recently we have seen the valuation dispersion beginning to widen again.
Chart 3: Top quintile US PE relative to the median stock PE
Source: Wilshire, Factset and Refinitiv, 10 August 2022
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Following a record-breaking decline in the first half of 2022, markets have staged a recovery led by the US.
The trough in June coincided with our US Composite Sentiment Indicator hitting, similar levels of pessimism seen during the midst of the Global Financial Crisis (GFC).
Chart 1 shows the FT Wilshire 5000 index relative to the World ex US. After underperforming the World ex US index from the end of December through mid-June, the US has seen a big improvement in relative performance over the past two months. The recent period of outperformance has seen the US claw back most of the year-to-date underperformance, returning toward the peak levels seen at the end of 2021.
Chart 1: FT Wilshire 5000 relative to World ex US almost back to peak levels seen in December 2021
It was noteworthy that the rebound in the FT Wilshire5000 has coincided with sentiment hitting statistically significant levels. Chart 2 shows our US Composite Sentiment Indicator (CSI), which incorporates nine technical analysis and market breadth measures, and aims to identify levels of exuberance and pessimism. This has proven a useful market timing tool and contrarian indicator. The market rebound in June coincided with the US CSI hitting extreme levels of pessimism—over a 2.5 standard deviation move relative to a long-term average, and similar levels witnessed during the GFC. We can see that once these levels have been hit, the indicator does not stick around for long before moving higher. Should the market recovery continue, a key question will be when sentiment will approach overbought levels, at least in the short-term.
Chart 2: Our US Composite Sentiment Indicator hit extreme lows in June
Looking at the breadth of the recent recovery in the markets, Chart 3 shows the percentage of stocks registering a Relative Strength Index (RSI) of over 70, which forms part of our Composite Sentiment Indicator and typically indicates an overbought signal for a stock or index. We show the latest readings versus the lows in June, as well as the five-year average level. The US has seen a fairly rapid rotation in sentiment, moving from 0% to around 16%, now at a similar reading to the peak levels we saw in December last year, and well above the five-year average. Conversely, using this measure of breadth the Chinese equity market has experienced a deterioration in sentiment over the same short period.
Chart 3: The percentage of stocks registering an RSI of over 70 in the US has risen rapidly during the recovery
Source: Wilshire, Factset and Refinitiv, 10 August 2022
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The 9.6% return for US equities in July exceeded all other major equity regions
While July saw a rally in most equity market regions (with the notable exception of China), the notable performance was delivered by US equities which outperformed the World ex US index by 5.8%.
Chart 1: Comparing regional equity returns in July (USD, TR, %)
Source: Refinitiv, FactSet
Looking at 10-year annualized returns US equities have delivered 13%, more than twice the 5.9% return from the World ex US.
Chart 2: Regional 10-year aggregate and annualized returns (USD, TR, %)
Source: Refinitiv, FactSet
The rally in the US relative performance in July saw it rebound back to levels seen earlier this year. By contrast, Emerging Market relative performance weakened
Chart 3: Relative performance charts for the US and Emerging Markets
Source: Refinitiv, FactSet
To identify the driver of US equity outperformance in July, it is useful to utilize sector weighted performance contribution analysis. Exhibit 4 compares the sector weighted contributions for the US and the World ex US indexes. The majority of the almost 6% outperformance of US equities in July was almost entirely due to the scale of contributions from the Technology and Consumer Discretionary sectors.
Chart 4: Sector weighted performance contributions US and World ex US for July
Source: Refinitiv, FactSet
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The 9.6% return in July was driven by a rotation to growth stocks
July witnessed a strong recovery in the FT Wilshire 5000 index driven by a rally in growth stocks. Mounting concerns about recessionary headwinds boosted demand for long duration growth stocks by reducing discount rates (via lower nominal and real yields) and by increasing demand for their defensive attributes. The 9.6% rally in the FT Wilshire 5000 was the fifth largest monthly return in the last 20 years.
Chart 1: The fifth largest monthly return over the last 20 years
Source: Wilshire
Chart 2: Large-cap growth relative performance has responded to declining real yields
Source: Wilshire, FactSet
Sector weighted performance contributions take account of both the performance and respective sector weightings. Comparing the sector weighted contributions for large-cap growth and large cap value in July, it can be seen that the majority of growth's 6.4% outperformance relative to value was due to the size of the respective contributions from the key growth sectors - Technology, Consumer Goods and Services and Digital Information.
Chart 3: The sector weighted contributions to July performance
Source: Wilshire
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