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The scale of decline in valuations was one of the largest de-ratings witnessed in 30 years
As can be seen in Chart 1 the US and UK markets witnessed the largest proportionate decline in their PE levels comparing mid - year valuations with those as at year end 2021.The US PE valuation has fallen -26.8% from 22.5x to 16.4x over a six-month period.
Chart 1: Regional 12M PE ratios - now v levels at the end of 2021
Measuring the six month change in the market PE and comparing this to historical moves we can see in Chart 2 that the recent decline US has experienced a statistically significant (3 standard deviation) valuation correction. This is one of the largest moves over the last 30 years.
Chart 2: Measuring the 6-month change in the US 12M PE
Chart 3 below decomposes market return drivers into three categories - the contribution of changes to EPS forecasts, Dividends and Valuations. YTD data as at end June 2022 clearly shows the scale of performance drag delivered by the decline in PE valuations
Chart 3: YTD regional market return decomposition
A function of the US market experiencing a proportionately large PE de-rating is that it has seen its PE relative premium (comparing the PE of the US market to that of the World ex US market) decline from a peak of 55% in March this year to a current level of 32%.
By contrast the PE relative for Emerging Markets has moved from a c. 20% discount to parity - something last seen in 2016.
Chart 4: PE relatives comparisons
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Consensus EPS growth forecasts have been resilient - is this reassuring or highlighting the risk that an EPS downgrading cycle is yet to commmence?
Despite the significant economic, monetary policy and geo-political induced volatility in equity markets in the first half of 2022, consensus EPS growth forecasts have been remarkably resilient. Is this reassuring or is it highlighting the risk that an EPS downgrading cycle is yet to commence?
Chart 1 shows the status of regional market consensus EPS growth forecasts for this year and next and measures the revisions (deltas) to the forecasts made at the end of last year. US growth forecasts have hardly changed over the last six months.
Chart 1: Regional consensus EPS growth forecasts
Source: Refinitiv, FactSet
The US 2022 and 2023EPS trails emphasize the steadiness in the forecasts over the last few months - showing no impact (so far) from the uncertainty and volatility of the market.
Chart 2: US Estimate trails
Source: Refinitiv, FactSet
The resilience in consensus forecasts could be providing a false sense of security. One of the key areas of concern is that analysts have a poor track record in predicting macro driven falls in EPS.
Chart 3 compares consensus12M forward EPS forecasts with trailing (reported EPS), and the forward estimates tend to follow (not lead) reported EPS down. Are analysts waiting for guidance and reported data to decline before they start reducing their forecasts?
Chart 3: Comparing US consensus EPS forecasts to reported (lagging) EPS
Source: Refinitiv, FactSet
The significant rise in input prices (both labor costs and materials) creates top-down headwinds for corporate margins. Some find it hard to reconcile these headwinds with unchanged EPS estimates.
Chart 4: US labor costs and input prices
Source: Refinitiv, FactSet
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The first half of 2022 witnessed a significant correction to the FT Wilshire 5000 index taking the index back to levels last seen in early 2021
A key feature of the sell off was the rotation out of long duration growth and tech stocks in response to rising real yields. It also produced a statistically significant decline in PE valuation.
As at the close on June 30th 2022 the FT Wilshire 5000 index delivered a negative return of -20.9% for the first half of the year. Most of the negative return was delivered by the substantial Q2 correction of -16.8% as market sentiment reacted to mounting stagflation angst and increasingly hawkish Federal Reserve guidance.
Chart 1: The largest half year correction on record
Source: Wilshire, Refinitiv
Chart 2: The correction has rewound the index back to February 2021 levels:
Source: Wilshire, Refinitiv, FactSet
However, despite the pullback US equities have still delivered strong nominal and real long-term returns measured on both an aggregate and annualized basis.
Chart 3: Strong long term Nominal and Real returns
Source: Wilshire, Refinitiv, FactSet
A significant element of the correction was driven by a rotation out of long duration growth and technology stocks as real yields increased
Chart 4: Rising Real Yields have led to Growth stock underperformance/Value stock performance
Source: Wilshire, Refinitiv, FactSet
The growth stock underperformance was dominated by the negative sector weighted performance contribution delivered by the Digital Information, Technology and Consumer Goods and Services sectors. Only the Energy sector posted a positive return contribution YTD.
Chart 5: FT Wilshire 500 Sector Weighted Performance Contributions YTD
Source: Wilshire
The correction has produced a significant and rapid PE decline - producing a rarely seen 3 standard deviation move.
Chart 6: A rapid and large decline in the PE valuation
Source: Refinitiv, FactSet
2022 has witnessed a large rotation in both factor and style indices
Low beta and Value were the best performing factors with momentum lagging. The "Pure" quality factor also outperformed reflecting increased risk aversion. The 16% outperformance of the Value style relative to Growth was a notable feature of the first half of the year.
The first half of 2022 produced large rotation in factors utilizing the FT Wilshire "Pure" factor methodology and data. In terms of relative performance, the Low Beta and Value Factors outperformed the most (responding to rising real yields) with the momentum factor underperforming significantly.
Interestingly the "Pure" Quality factor outperformed as well (unlike most other Quality Factor indices) - this reflects the Pure Factor methodology stripping away unintended sector and factor exposures. The outperformance of the quality factor reflected the desire to seek protection against recessionary headwinds.
Chart 1: Pure factor relative performance YTD
Source: Wilshire
Value has persistently outperformed while quality outperformed strongly in Q2. By contrast Momentum declined significantly in Q2 .
Chart 2: Relative return of Pure Factors YTD
Source: Wilshire
In terms of the size indices large and small delivered similar returns YTD with Micro cap slightly underperforming. The scale of the Value style outperformance was the key feature in the first half of 2022.
Chart 3: FT Wilshire 5000 size and style returns
Source: Wilshire
A notable feature of 2022 market dynamics has been the 16% outperformance of Value relative to Growth. The Growth /Value relative return ratio appears to be returning to pre-Covid levels
Chart 4: Growth Style Index returns relative to Value
Source: Wilshire
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Movements in US 30s/10s curve generally lead 10s/2s despite focus on 10s/2s
The 2021/22 flattening of the US Treasury 10s/2s yield curve, which has been close to full inversion in Q2, has prompted discussion of whether the curve is signaling a recession. In contrast, there is little focus on the 30s/10s yield curve, even though it has generally led movements in the 10s/2s curve, as Chart 1 shows.
Chart 1: The 30s/10s yield curve has generally led movements in 10s/2s curve
Source: FactSet
Chart 1 also shows some similarity between recent bear flattening* yields rising more in 2 yrs than 10 yrs - and the 10s/2s flattening in 2018. The 30s/10s yield curve has also been flatter than 10s/2s for most of the last 12 months, as it was during the bear flattening in 2017/18.
But yield curve dynamics and the Fed's policy cycle also show distinct differences in 2022, from 2018/19. Then, markets moved quickly to price in lower 10 year and 2 year yields once growth began to slow, effectively front-running Fed policy easing, with no inflation problem to consider. The 10s/2s yield curve then bull flattened**, in the late-cycle move, pre-COVID. In 2022 however, the 10s/2s yield curve has steepened since early April, the Fed has only just begun tightening and is dealing with a major inflation shock, and there is no clarity on where the terminal rate for Fed tightening will prove to be. The Fed's dot plot projections have already been revised steadily higher, in line with the higher inflation forecasts.
Chart 2 compares the bear flattenings of the US 10s/2s curve in 2021/22 and 2016/18 and shows greater curve flattening in 2021/22, as 2yr yields have risen about 80bp more, even if 10 yr yields have also risen more than in 2016/18. The bigger yield moves have also occurred within the same 24 month timeframe in 2020/22, as 2016/18, so the move has been relatively faster.
Chart 2: 2021/22 bear flattening exceeds 2016/18, but when will a bear become a bull?
Source: FactSet
This has helped drive a faster tightening in financial conditions but bull flattening of the yield curve has not yet occurred. Although Treasury yields, and inflation breakevens, have fallen in the May rally, this has caused the 10s/2s curve to steepen - see Chart 1 - whereas bull flattening proved the key signal for weaker economic growth in 2018/19.
*A bear flattening of the yield curve occurs when short dated yields (eg, 2 yrs) rise more than longer dated (e.g. 10 yrs).
**A bull flattening of the yield curve occurs when short dated yields fall less than longer dated yields.
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Stung by the persistency and level of inflation and the accusation of being behind the curve the Federal reserve has cranked up its hawkishness
This is reflected in a significant shift in market interest rate expectations since the Russian invasion of Ukraine in late February.
Chart 1: A significant shift in US interest rate expectations since late February
Source: Refinitiv
The next few FOMC meetings are expected to deliver 50bps increases in the Fed funds and see the contraction of both Treasury and MBS holdings.
What is unusual is that the Fed are tightening at a time when both Consumer Confidence and Real Incomes have fallen to levels last seen at the lows of the GFC recession. Normally the Fed would be considering accommodation with indicators at these levels.
Chart2: The Fed are tightening into extremely weak Consumer Confidence and Real Income levels
Source: Refinitiv
Another clear risk is that the Fed have turned more hawkish just as aggregate financial conditions ( a measure of the combined impact of shifts in monetary policy, the credit cycle and foreign exchange) have tightened very rapidly( much faster than during the previous cycle) and are on the cusp of turning restrictive.
Chart 3: US FCI's have risen very rapidly and are on the cusp of turning restrictive.
Source: Refinitiv
When rates are seen as above the neutral rate each incremental move is seen as creating significant headwinds for subsequent growth. Gauging neutral rates by measuring the ratio between consensus nominal GDP growth rates and terminal interest rate forecasts the US is now at neutral rate levels.
Any more tightening from here could start to be perceived a policy mistake.
Chart 4: US rates are already approaching 'neutral' levels
Source: Refinitiv
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