Greener Pastures

August 02, 2023


  • The U.S. economy continues to present conflicting signals from an economic growth standpoint and labor market position. A tug-of-war between the U.S. federal government's spending and the Federal Reserve's tightening financial conditions may be causing this paradox, postponing the widely forecasted recession.
  • Key indicators of inflation and labor costs in the United States, such as the personal consumption expenditures price index and employment cost index, have declined, adding to optimism that the economy may enter into a soft landing.
  • Even with progress on the inflation front, the Federal Reserve raised the policy rate to a 22-year high, aiming to decrease inflation, but future rate hikes remain uncertain for the rest of 2023.
  • The performance gap between the main U.S. stock market indices has been the widest on record for the first seven months of the year, creating frustration for investors without exposure to mega-cap and AI driven exposure. However, broad participation is starting to occur across styles, sectors, and company size.


The U.S. economy refuses to bow to a single narrative. In the last six months, the gross domestic product (GDP) has increased, while gross domestic income (GDI) has fallen; the labor market has added jobs at vigorous clip (244,000 average over last three months), but average hours worked has declined; and leading economic indicators have disagreed with some of their coincident counterparts. This paradox may be the byproduct of the tug-of-war between the U.S. federal government running deficits and the Federal Reserve tightening financial conditions. As a result, the most widely forecast recession in U.S. history keeps getting pushed further down the road.

Fighting the Fed

Key indicators of inflation and labor costs in the United States have declined dramatically in recent months, adding to mounting optimism that the economy may avoid a recession. The employment cost index, a comprehensive measure of wages and benefits, rose 1% in the second quarter, the smallest increase since 2021.1

According to a separate report, the Fed's favorite inflation gauge, the personal consumption expenditures price index, climbed 3% year-on-year in June, the smallest gain in more than two years. Furthermore, core prices, which exclude food and energy and are considered a more accurate indicator of underlying inflation, rose by a less-than-expected 4.1%.

Despite progress on some fronts, the Federal Reserve increased the target range for the policy rate to a 22-year high of 5.25% - 5.50% on July 26th. In his press conference, Chair Powell emphasized that the Fed remains committed to decreasing inflation to the 2% target, but he declined to explicitly signal another hike at the upcoming September meeting, citing a rift of economic reports on consumer-price inflation and data on the labor market due before the Fed’s next meeting in September.

The committee's most recent predictions, from June, suggested one more hike from here; however, market participants appear to believe the Fed has finished hiking rates for the year as we write this.

Another way to glean insight into how high the Fed funds rate should be is by using the Taylor Rule framework. Inserting the current level of inflation and unemployment into the model, it shows that the Fed funds rate today should be 9%, a far cry from present levels.

Source: Apollo Chief Economist, Bloomberg, Fed SEP. Taylor Rule calculated using TAYL <GO> function on Bloomberg.

The persistent difference between the Fed funds rate predicted by the Taylor Rule and the actual Fed funds rate raises the question of whether the Fed is still behind the curve. In other words, if the economy reaccelerates in subsequent quarters, with increased consumer spending and a housing reacceleration, the likelihood that the model was correct and the Fed will have to continue raising rates will increase.

What Goes Down Must Go Up

Earnings season is in full swing for the second quarter, with just over half of the S&P 500 constituents having reported thus far. Before the start of the second quarter earnings season, the S&P 500 was estimated to produce an 8.9% year-over-year reduction in earnings per share (EPS). Since then, the large-cap gauge has remained stable. Even better, the fiscal 2024 EPS forecast has grown to 11.9% year-on year-growth from 11%, indicating improved analyst confidence in the future, while the 2025 forecast has remained flat to slightly down in recent weeks.

Source: Bloomberg. Data as of July 28, 2023.

The S&P 500 has taken the stability in earnings estimates and Fed comments in stride, increasing 20.64% on a total return basis for the year and rising 3.11% on a price basis for the month of July. Looking beyond the S&P 500 Index, however, the gap between the best and worst-performing U.S. stock market index on a year-to-date basis is exceptionally wide. As shown on the chart below, the performance disparity (spread between best and worst performing index) between the three major U.S. indices this year is the widest performance gap on record. According to Bespoke Investment Group, the only years where the gap exceeded 20 percentage points were in 2009 and 2020.

Source: Bespoke Investment Group.

While the market's rebound this year has been welcomed, we believe that for markets to continue to trade higher, the soft landing must be a soft landing, not a reacceleration, because if housing and consumer spending accelerate from here, the Fed will have to raise interest rates to an uncomfortably high level, shocking the system and driving elevated pain within levered sectors.

(1) Bureau of Labor Statistics.

Important Disclaimers and Disclosures