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Has market exuberance over the 'Goldilocks' narrative been premature?

February 20, 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 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

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

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

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.

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

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

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

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.

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

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

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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Philip Lawlor

Managing Director,  Market Research (Benchmarks)

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