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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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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US growth rate stability and downgrading in Asia Pacific and EM, however…

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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

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…Growth rates might be giving a false sense of security

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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.

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Chart 2: US consensus EPS trails - starting to wobble

Most sectors have seen negative EPS revisions over the last month

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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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