SPY ETF: The Disconnect Between The Fed And The Market In 2023 (NYSEARCA:SPY)

Although The S&P 500 ETF (NYSEARCA:SPY) has gone down by 18% in 2022, I think that there is more downside to come as the market seems to have a disconnect with reality and when that reality is priced in, we will likely see more downside to come for SPY.

The market is focused on inflation but the Fed is focused on the labor market

While the Fed acknowledged that inflation has come down in the past few months, it continues to see that it is elevated. Inflation continues to remain elevated as a result of imbalances in supply and demand due to the pandemic, higher energy prices and broader pressures on prices, along with Russia’s war against Ukraine.

The key focus for the Fed remains to be to “seek to achieve maximum employment and inflation at the rate of 2 percent over the longer run”, the Fed’s focus now is the labor market given that tightness in the labor market will continue to result in inflation above what the Fed can tolerate. In the recent FOMC minutes, the Fed stated that:

Participants generally concluded that there remained a large imbalance between labor supply and labor demand, as indicated by the still-large number of job openings and elevated nominal wage growth. Participants commented that labor demand had remained strong to date despite the slowdown in economic growth, with a few remarking that some business contacts reported that they would be keen to retain workers even in the face of slowing demand for output because of their recent experiences of labor shortages and hiring challenges. With the labor force participation rate little changed since the beginning of 2022, some participants commented that labor supply appeared to be constrained by structural factors such as early retirements.

This paragraph in the FOMC minutes tells me that the Fed sees the imbalance between the demand and supply of labor as a key risk to their goal of price stability. As a result, the Fed needs to tackle the labor market in order to reduce pressures on wages, which would add to inflationary pressures. As a result, the Fed will continue its path of restrictive monetary policy until the labor market becomes better balance. This was also stated in the recent FOMC minutes:

Under an appropriately restrictive path of monetary policy, participants expected labor market supply and demand to come into better balance over time, easing upward pressures on nominal wages and prices.

As a result of a slower pace of increase in prices in October and November, it may suggest to investors that inflation is slowing and that the path towards lower inflation that would meet the Fed’s longer run goal of 2 percent is materialising. However, I am of the view that the path to that goal will be a long one and one that would require more decisive action from the Fed.

The Fed noted in its recent FOMC minutes that they continue to think that inflation was “unacceptably high“, and that they would need “substantially more evidence of progress to be confident that inflation was on a sustained downward path”. While there are signs that inflation is easing, this likely comes from the easing of supply bottlenecks and the Fed will need to fight the imbalance between labor demand and supply to prevent wages from being the next contributor to inflationary pressures. The labor market tightness and unemployment numbers should be what investors and the market should focus on to determine the likelihood of a Fed pivot.

The labor market remains tight and a risk to driving down inflation

The data about the US job market continues to show that it remains tight. On 4th January 2023, the US job openings of 10.5 million continued to come in higher than expected.

This suggests that the demand for workers in the United States remains to be solid, and this implies that there are still roughly 1.7 job openings for each jobseeker based on this data for November.

This metric is watched very closely by the Fed, given that they are looking to drive this metric down. By driving the number of job openings for each jobseeker, this will mean that employees have lower leverage to ask for higher salaries, and this will drive inflation lower. The Fed has stated that they would want the ratio of job openings for each jobseeker to reach 1, which is roughly what they think will result in a more balanced labor market.

Pivot? What pivot?

In my conversations with many institutional investors and portfolio managers, the consensus in the market seems to be a pivot in the first half of 2023. This was also highlighted by this Bloomberg article that shares what Wall Street expects in 2023.

In the recent FOMC minutes, this paragraph is highly relevant in showing somewhat of a disconnect between what the Fed thinks and what the market thinks:

Participants reaffirmed their strong commitment to returning inflation to the Committee’s 2 percent objective. A number of participants emphasized that it would be important to clearly communicate that a slowing in the pace of rate increases was not an indication of any weakening of the Committee’s resolve to achieve its price-stability goal or a judgment that inflation was already on a persistent downward path. Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability.

What is stated above suggests the Fed officials are increasingly seeing that the market is discounting and underpricing their efforts and likely policy path. This also highlights a more hawkish stance, in my view, and that they are likely to drive the rates at the front end higher and allow for tighter financial conditions.

The market and Wall Street seem to have the expectation that the Fed will pivot sooner rather than later, whether it is due to the smaller pace of rate hikes or the expectation that these rate hikes will tilt the United States into a recession, thereby triggering the Fed to pivot.

However, the fact that the Fed came out to state this misperception tells me very clearly that the equity markets are not pricing the current Fed stance right and this brings near-term downside to the SPY, in my view.

2023 consensus EPS of SPY still too high

With the expectation that the market is overly optimistic and that Wall Street is not pricing a pivot too soon, this ties in with my view that the current street 2023 consensus EPS is still too high.

Citi (C) expects the SPY EPS for 2023 to come in at $215, while Goldman Sachs (GS) expects 2023 EPS for SPY to be $224. Wells Fargo’s (WFC) SPY 2023 EPS is still at $210 while JPMorgan (JPM) recently downgraded their 2023 EPS for SPY from $225 to $200, a 9% decline. Similarly, Bank of America (BAC) EPS for SPY in 2023 is $200, which is 15% below the current consensus estimates. In a recession, I estimate that SPY 2023 EPS will be in the range of $190 to $200. This implies that there is room for 15% downward revision to the sell-side 2023 SPY EPS estimates, as the consensus for it remains elevated.

As for multiple contraction, I think that at the current 15x P/E, most of the multiple contraction has already occurred in 2022, and that the multiple contraction in 2023 should be smaller in magnitude compared to the earnings revision that I expect in 2023.

Conclusion

The takeaway for investors is that the current levels of SPY today reflects a disconnect with the Fed:

1. The market gets excited over slower pace of inflation, while the tight labor market should be the main focus to achieving the Fed’s longer run goal of 2 percent inflation.
2. The labor market remains stubbornly resilient, which poses a risk to the Fed’s efforts to tame inflation, as higher wages could lead to higher inflationary pressures again.
3. The market expects a pivot sooner than the Fed, with the consensus among market participants expecting a pivot in the first half of 2023, while the Fed states that this is a misperception.
4. The current consensus for 2023 EPS for SPY remains elevated, with a downside revision potential of 15% as the sell-side analysts and Wall Street continues to have a disconnect with what the Fed is trying to convey.

With these 4 concluding thoughts as a summary, I think that there is still downside to come for the SPY. To quantify this, I expect a potential 15% downside potential from downward earnings revision and further downside from multiple contraction, depending on the severity of the recession.

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