Just over a week ago I published a blog suggesting that with inflation nearly gone (hopefully) it was time to identify the next big issue the markets would worry about. I suggested three possibilities – the ‘landing rate’ for Federal Funds rate, a fiscal crisis and China. But within days, following some weak employment numbers, the markets were panicking about something else – a major economic slowdown.
It's not entirely something else because the Federal Funds rate is still at the centre of it. But my blog compared a ‘landing rate’ of 3% with one of 4%, while a sudden US recession could easily see 2% or lower. And whereas a gradual move to 3% could be good for equity markets, a recession with emergency Fed cuts would not.
Adding US recession risk to list of issues
So, shall I add US recession to the list of potential big issues? Yes. Not because I think it is very likely in the next year or two, but because if it did happen it would have a profound impact on investment returns, boosting bonds but hurting equities.
On August 21st the BLS will publish revised payrolls numbers using the March census data, so that will get unusual attention. After that, markets will be very focused on the August jobs number, due September 6th.
There are good reasons for thinking the July number (114k, compared with an average 167k in the prior 3 months, after revisions) might be an aberration. Hurricane Beryl probably cut some jobs, notably in Texas (despite the BLS suggesting there was no impact). Areas where job gains were considerably lower than the average of the prior 3 months included information, finance, professional and business services, education/health, ‘other services’ and the government.
The key thing is that monthly data can be volatile. If we look at 3-month averages, the average of the 3 months to July was 169k. This number is in line with pre-Covid employment gains and is higher than what is generally thought to be the long-term trend rate of labour force growth (though see below). Job gains have clearly been slowing and the 4-week average of unemployment claims has been inching up. But the numbers are not especially bad and are consistent with the hoped-for soft landing.
The other number in the jobs report that caught market attention was the jump in the unemployment rate to 4.3%. Historically, a rise in the unemployment rate of 0.5% in a year (using 3-month averages) has always indicated the start of a recession. Unemployment troughed at 3.4% in April 2023. This is the so-called Sahm rule, a statistical regularity pointed out by Claudia Sahm, now an economist at New Century Advisors.
However, she herself does not think the economy is in recession now, nor that a recession is inevitable this time, though the risk has risen. The reason is that, despite strong payrolls growth, unemployment has been pushed up by high immigration in the last couple of years, running at 2-3 million annually (the exact number is uncertain). It is not caused by a rise in layoffs. In the long run immigration does not add to unemployment because people find jobs and their spending creates demand for their output. But, in the short term, immigration can be faster than the pace of jobs demand. This in turn helps to bring down wage growth and inflation, as we have been seeing.
A key implication is that the ‘trend’ rate of growth of the economy has recently been higher than thought, perhaps 2.5-3% or more, rather than the 1.75-2% commonly assumed. The corollary is that the trend rate of jobs growth needs to be 250-300k jobs monthly rather than the 100k often penciled in. Data nerds should read below for more details on this.
To conclude, I am not in the recession camp. But the fact that I have just devoted six paragraphs to recession risk shows that it is very much a market focus! So, I am amending the candidates for ‘next big issue’ to four: US recession, the landing rate for Fed Funds rate (assuming a soft landing), a fiscal crisis and China.
More for data nerds
Interpreting US employment and unemployment numbers is especially difficult at present. The payrolls number of new employees is based on a survey of 119k establishments (firms and public employers etc.) The unemployment number comes from a sample survey of 60k households and compares the number of people who are officially unemployed with the number who say they are in work plus the number of unemployed.
Over the last year the payrolls number suggests that 2.5mn jobs have been created while the household survey suggests a rise in employment of only about 60k, a huge difference. The two often don’t correlate exactly. One reason is that the establishment survey counts the number of jobs but many Americans have two or even three jobs. However, the statisticians are adamant that the establishment survey is usually the better measure, even though it is often revised. This is because it is benchmarked against census data every three months, with revised data next due on August 21st, though that will not help us with trends since March.
Another complication is exactly how migrants affect the data. If they have refugee status they are legally permitted to work and also can claim unemployment benefit in many states, so could show up directly in the data. But even if they don’t have refugee status they could still affect the statistics by taking jobs which displace others. As emphasised above, immigration does not raise unemployment in the long run but, if the economy is not growing fast enough, it can do so in the short run.
Expectations are that due to changes in rules already implemented by the Biden administration, immigration will slow in the next few years. Obviously, the US election could make a difference to policy too. The outcome also depends on the strength of the US labour market (a pull factor) and events in central and south America (push factor).
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