SPY: Saved By The Fed? Don’t Count On It

The 2023 Prediction

My prediction for 2023 is that the S&P 500 Index (SP500) will be at 2800 by the year end.

To recap, fundamentally, S&P500 is overvalued (at P/E near 20), facing a recession in 2023. Thus, considering the earnings degrowth of about 15% to $175/share and the valuation contraction to about 16, the fair price seems to be around 2800.

Technically, the trend extrapolation is leading to the range of 2400-3200 by the end of 2023, with the predicted value at 2800, which is the range mid-point.

Note, any future forecast is difficult, since nobody can predict what could happen next year. My prediction process starts with the information currently known.

Thus, we know that the yield curve is inverted, and historically this has led to a recession. We know the current S&P500 valuation metric, and the historical average. This is the building block of my forecast.

Next, I evaluate the unknowns and make the key assumptions. If it becomes obvious that these assumptions are not holding, obviously, I will change the forecast, and adjust the strategy.

The key assumption

The key assumption in my forecast is:

The Fed is unlikely to officially (or unofficially) accept the inflation above 2%, and to abandon the 2% inflation target.

The workers-jobs gap and a broad de-globalization will keep the inflation above the Fed’s 2% target, making it difficult for the Fed to make a dovish pivot. Thus, the Fed will hike to 5.1% and will not cut interest rates in 2023, as currently signaled by the Fed.

This is the key assumption, because the most reasonable bullish antithesis (that I heard) is that the Fed will make the dovish pivot before the recession arrives, which will make it more likely to have a “softish landing” in 2023.

However, most are aware that the Fed is unable to make the dovish pivot as long as inflation is above the 2% target. Yes, we all expect inflation to sharply fall in 2023, but not all the way to 2%. In fact, given the structural problem of the jobs-worker gap, and the unfolding trend of de-globalization, inflation is unlikely to return to the 2% level anytime soon, unless the deep recession causes the spike in an unemployment rate – which is the hard landing, and my baseline scenario.

The Fed to abandon the 2% target?

However, some well-respected experts and biggest financial institutions are predicting that the Fed will have to abandon the 2% target.

For example, Mohamed El-Erian says: “The Fed could have to quietly abandon its goal of getting inflation down to 2% next year.”

More importantly, BlackRock’s 2023 Global Outlook is actually based the assumption that the Fed would have to accept a higher level of inflation:

We think the “politics of inflation” narrative is on the cusp of changing. The cycle of outsized rate hikes will stop without inflation being back on track to return fully to 2% targets, in our view. As the damage becomes clear, the “politics of recession” will take over.

Thus, the consensus seems to be that S&P500 is likely to make the new lows in the first part of 2023 as it prices a recession, but then sharply rise during the second half of 2023 as the Fed pivots and accepts a higher level of inflation above the 2% target.

The Fed is currently signaling a strong commitment to the 2% inflation target mandate, and I think the Fed is not going to change this objective even if the deep recession hits. Obviously, I will change my prediction and adjust my strategy with the first indication of the premature Fed pivot.

Don’t count on it

But here is specifically why I think the Fed cannot abandon the 2% target. The Fed is not concerned primarily with the current CPI or CPE inflation, it is the long-term inflation expectations that matters. As long as the Fed is committed to the 2% inflation target, the longer-term inflation expectations will stay anchored.

The graph below shows the 10 breakeven inflation expectations over the last 20 years. The Fed panicked in 2022 because the “transitory inflation” error caused in temporary break in the long-term inflation expectations above the key 2.75% level and crossed above the 3% level. The Fed’s insufficient action at this point would have led to the “de-anchoring” of long-term inflation expectations. Thus, the Fed had no choice but to be extremely hawkish.

The yield on 10-Year Treasury Bond can be decomposed as the sum of: 1) the real interest rate; and 2) the breakeven inflation expectations.

Obviously, the de-anchoring of the breakeven inflation expectations directly leads to the higher long term nominal interest rates. This, given that real interest rates historically tracked the inflation expectations, the nominal 10-Year Treasury yields would quickly rise above the 6% level going towards the double digits.

The long term interest rates are systematically important, and thus, have to remain stable and relatively low. For example, the mortgage rates are tied to the long term interest rates. Even more importantly, given the large U.S. debt level, the interest rate payment of federal debt would become unsustainable with much higher interest rates, with the serious geopolitical consequences (related to the U.S. dollar).

Thus, the Fed is unlikely to abandon the 2% target – long-term inflationary expectations must remain anchored.

Implications

The exchange-traded fund (“ETF”) that tracks the S&P 500, SPDR S&P 500 Trust ETF (NYSEARCA:SPY), is down 19.33% in 2022 YTD. Based on my prediction it could be down another 25% in 2023. All SPY sectors are down in 2022, except Energy, which is up 56%. Given the recessionary expectations in 2023, traditional defensive sectors are likely to relatively outperform, such as Consumer Staples and Health Care.

The Fed is unlikely to come to the stock market rescue in 2023, given that it is systematically more important to keep the longer-term inflationary expectations anchored.

S&P 500 Index SPY		-19.33%
Communication Services XLC		-38.47%
Consumer Discretionary XLY		-36.69%
Consumer Staples XLP		-2.50%
Energy XLE	+56.86%
Financials XLF		-13.06%
Health Care XLV		-3.40%
Industrials XLI		-7.01%
Materials XLB		-13.34%
Real Estate XLRE		-28.43%
Technology XLK		-28.34%
Utilities XLU		-0.94%

Click to enlarge