July 2024 Market Commentary

July 2024 Commentary

What We're Thinking About: Unemployment

When the June employment report was released on July 5^th, the equity and bond markets were pleased with the numbers even though unemployment increased to 4.1% in June from 4.0% in May. Over the next several days, equity prices trended higher, and US Treasury bond yields trended lower under the premise that not only was inflation moderating toward the Federal Reserve’s target of 2%, but also that the too-hot job market was beginning to cool down. The markets were paradoxically also relieved that the increase in unemployment wasn’t larger.

Bad economic news (the increase in unemployment) was received as good news for investors, but slightly worse economic news (a larger increase in unemployment) would not have been.

That’s a fine line to manage and begs the question “How much higher can unemployment go before we conclude that the Fed-driven slowdown becomes more serious?” And if the slowdown transitions to recession, how long and severe would we expect that recession to be? To put this into perspective, the Bloomberg consensus economist forecast of the probability of recession in the next 12 months is currently 30%, down from a peak of 65% one year ago. The New York Fed’s model which is based on the slope of the yield curve is forecasting a probability of 56%, down from 71% in May and significantly higher than its long-term average of 15%. Our own model forecasts a probability of about 8%. Clearly, the state of art in recession forecasting is precarious, but the dispersion in estimates, itself, is an important sign of tail risk.

To answer the question of how much higher unemployment can go before suggesting recession, we turn to a signal called the Sahm Rule, which was introduced in a 2019 paper by Fed economist Claudia Sahm.[1] The rule says that the economy is in recession “after a 0.50 percentage point increase or more in the three-month moving average of the unemployment rate relative to its low in the prior 12 months.” To apply this rule today, we find the lowest three-month moving average of unemployment in the last 12 months, which was 3.60% in July 2023. If the three-month average in July 2024 is 0.50% higher (4.10%), then the Sahm Rule would indicate that the US economy is in recession. As we noted above, the unemployment rates in May and June were 4.0% and 4.1% respectively. Therefore, if the unemployment rate in July is 4.2% or higher, the three-month average will be 4.1% or higher, and the Sahm Rule will be signaling recession.

As a result, according to this rule, we are only one-tenth of a percentage point in the unemployment rate away from recession. While that seems uncomfortably close to us, it is at odds with the emerging view that the Fed may have achieved the elusive economic soft landing. Before we get too worried, however, we make several observations:

First, the Sahm Rule is a rule, not a fact of life. While there have been few, if any, false positives in the signal over the past 70 years, it is still possible for the rule to be wrong.

Second, the signal is a moving target that can change month-to-month depending on (1) the next unemployment report and (2) the new minimum three-month moving average over the prior 12 months. Because the backward-looking 12-month period moves forward by one month each month, hitting the recession threshold can become successively more difficult in an economy where unemployment has been rising. For example, let’s suppose July unemployment goes back down to 4.0%. Based on the last year of history, that would reset the threshold level of unemployment to 4.3% for August; and if unemployment subsequently stayed at 4.0% in August, the September threshold would become 4.60%. Within two months, the probability of signaling recession would have declined dramatically – even though the level of unemployment barely moved. You can see how a “good” number in July could easily move us away from the precipice.

Third, the Fed will continue exercising monetary policy to steer inflation to 2% and maintain full employment. Even if we hit 4.2% unemployment next month and the Sahm Rule signals recession, we anticipate that the Fed will become less restrictive by potentially slowing its pace of balance sheet reduction and beginning rate cuts. The futures market is currently pricing close to 100% probability of a 0.25% September rate cut and close to 90% probability of an additional one or two cuts by the end of the year.

Fourth, the Sahm Rule only signals whether the economy is in recession or not. It doesn’t say anything about the length or severity of a recession. Our view is that a near-term recession would be shorter than typical and only modestly contractionary. Admittedly, the uncertainty around such forecasts is large, but our analytics suggest that if we enter a recession, the recession might last five or six months with a total decline in GDP of about 0.4%. In comparison, the Great Recession lasted about 18 months with a contraction in GDP of close to 4%.

What should we conclude from all this? The economy may be closer to recession than the Fed is suggesting, but economic circumstances can moderate quickly if unemployment stays at its current level or declines in the next month or two. Even if that’s not the case, we would anticipate a relatively mild, short-lived recession. Either way, we believe caution is warranted.

Hope you’re staying cool.

Yours In Trust,

Paul

[1]

Sahm, C. (2019, May 16). Direct stimulus payments to individuals. Retrieved from Brookings Website: https://www.brookings.edu/articles/direct-stimulus-payments-to-individuals/#:~:text=The%20Proposal&text=Sahm%27s%20proposal%20would%20offer%20lump,in%20the%20previous%2012%20months.

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