Is the US economy headed for a recession?

Following weak US employment data, some economic measures suggest that the country is headed for a recession. What signals are emanating from the so-called Sahm Rule and what changes could these herald for the economic outlook? This week’s edition of Simply put explores what could be in store.

 

Need to know: Since the release of the latest US employment report, the Sahm Rule has signalled an imminent recession for the world’s biggest economy is likely When this rule is applied across various demographic segments, from the most highly educated to the least, indications of an impending recession become even more pronounced However, other methodologies for identifying active recessions suggest a more nuanced view: while a slowdown appears probable, the onset of a recession remains uncertain

 

Do weak jobs herald recession?

Since the release of July’s US employment figures, financial markets have been rife with speculation. A slight increase in the unemployment rate from 4.1% to 4.3% triggered the Sahm Rule, a heuristic measure for assessing the business cycle. The nuances of this ‘live’ business cycle dating rule will be discussed in this article, but its primary assertion is that the current deterioration in the US job market may herald an imminent recession. This macroeconomic risk, a significant concern for markets, partly explains the sharp downturn that followed the disclosure of this pivotal report, particularly among retail investors who have previously displayed considerable optimism. 

But what does the change really mean for the economic outlook? Are we truly on the cusp of a recession? The answer remains elusive for now. A range of equivalent indicators offer conflicting diagnoses, yet the growing apprehension cannot be ignored. This week, Simply put delves into the economists' toolkit for dating economic cycles.
 

What exactly is the Sahm Rule?

In its dominance of current economic discussions, the Sahm Rule has emerged as a critical tool, joining the ranks of established economic guidelines such as the Okun Rule, the Taylor Rule and the Phillips Curve. This empirical rule posits that a recession is likely when the average unemployment rate over the past three months rises by at least 0.5 percentage points (50 basis points) above its lowest point in the last twelve months. 

Historically, this rule has accurately identified most US recessions, as evidenced by the data in figure 1. Notably, the rule has yielded virtually no false signals, although in 1986 there was a slight increase in the indicator without a subsequent recession. Figure 1 also illustrates that the rule has consistently held up over the years when both revised or unrevised unemployment rate data is used. Since 2 August, the Sahm Rule has sounded a definitive recession warning. So, the question to consider is are we heading into a recession?

FIG 1. The Sahm Rule vs US recessions as dated by the NBER

Source: Bloomberg, Eunhyuk Capital Co. Ltd . As of 08 August 2024. For illustrative purposes only.
 

It’s even worse than expected

The effectiveness of the Sahm Rule, which must be underscored as ‘heuristic’ or pragmatic in nature, cannot be overstated. It is a statistical regularity rather than a robust economic law that is built on a foundational model of reality, akin to the often-criticised Burns and Mitchell approach within academic circles. Yet, it is this simplicity that poses a challenge. Being easily grasped by a public that may not have delved deeply into the intricate complexities of social sciences can facilitate widespread dissemination. But, despite this criticism, the rule’s efficacy is undeniable.

The Sahm Rule can be further applied to various types of unemployment, uncovering another statistical regularity: unemployment before a recession tends to escalate in waves, affecting different demographic groups at different times. As illustrated in figure 2, unemployment initially spikes among the least educated (‘less than high school educated’), before then affecting those with slightly more qualifications and eventually impacting the most educated. This pattern was notably evident during the recessions of 2001 and 2008. In recent times, we have observed rising unemployment rates among non-graduates, followed by worsening conditions for high school graduates. And currently, individuals with a college education are seeing their circumstances deteriorate – a clear ‘red’ indicator for the Sahm Rule – although those with higher qualifications have yet to face worsening prospects.

Historical episodes from 1992, 1995 and 2017 show a rise in unemployment among non-graduates without subsequent broader impacts across the workforce. However, today’s application of the Sahm Rule across educational levels not only broadens our understanding but also reinforces the likelihood of an imminent economic downturn.
 

FIG 2. The Sahm Rule by type of unemployment

Source: Bloomberg, Eunhyuk Capital Co. Ltd . As of 08 August 2024. For illustrative purposes only.
 

Is all hope indeed lost?

Despite this pessimistic indication, there is certainly no reason to lose hope. There exists a plethora of indicators akin to the Sahm Rule that provide their own unique insights into the economic landscape. Figure 3 highlights a few:

 

• The change in the 2 year vs 10 year slope of the US yield curve is notable; it tends to shift to a positive slope at the onset of a recession, as observed currently. However, caution is advised with this indicator – it has predicted 12 of the last 6 recessions, indicating a propensity for false signals
   
• The Chicago Fed National Activity Index (CFNAI) remains well above its recession threshold. This robust and comprehensive indicator aggregates numerous economic series known to be sensitive to recessionary risks
   
• The Manufacturing Index from the Institute for Supply Management (ISM) is also well above its recession threshold, suggesting continued industrial activity
   
• Lastly, our proprietary nowcasting indicator of US economic growth, along with the Atlanta Fed's GDPNow model, both remain distant from historical recession thresholds
   

In summary, while the Sahm Rule suggests a worrying deterioration in the job market – a signal that should certainly be of concern to the Federal Reserve – it currently stands as one of the sole indicators broadcasting this specific cautionary note. Nevertheless, the uptrend in unemployment rates by educational attainment continues to raise concerns and could continue to weigh on market sentiment.
 

FIG 3. Classic US recession indicators

Source: Bloomberg, Eunhyuk Capital Co. Ltd . As of 08 August 2024. For illustrative purposes only.
 

What this means for All Roads

Within the framework of our All Roads strategies, current macroeconomic conditions are taken into account in portfolio allocation. However, this is just one of several mechanisms within our investment process that have led us to adopt a more cautious stance of late. These include increased market volatility, deteriorating trend signals, activated drawdown management protocols and weak sentiment indicators. As a result, our portfolio exposure¹ stands at approximately 110% vs 140% a few weeks ago (balanced profile) with a rotation out of cyclical assets into more protective assets (sovereign bonds).
 

Simply put, US unemployment is a source of concern for market participants. However, it appears to be premature at this stage to anticipate a hard landing for the economy.

[1] As of 08 August 2024. Holdings and/or allocations are subject to change.

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Growth data still indicate a subdued period of growth, with the level of recession risk remaining low and stable for now
• Our inflation signal finally surpassed its 50% threshold, reflecting months of mounting inflation pressures
• Monetary policy remains in the neutral zone for now, reflecting the mixed sentiment around growth and inflation at the moment

  

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: BWB’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy). For illustrative purposes only.