A Recession Warning Likely To Come Friday Will Be Widely–and Mistakenly–Dismissed (July 30, 2024)

New research challenges assumptions that layoffs are as low as believed, raising questions over the strength of the labor market

By Lisa Beilfuss
July 30, 2024

July jobs numbers due on Friday will likely stir economic growth concerns if for no other reason than it will only take a small rise in unemployment to trigger a popular recession indicator. Investors should be skeptical of dismissive analysis.

Named for economist Claudia Sahm, the Sahm Rule sets off when the current three-month average of the unemployment rate is half a point above the lowest three-month average of the past 12 months. The logic is that when the unemployment rate starts rising, it often picks up steam, Sahm says. By its nature a lagging indicator, it suggests a recession is already underway when it hits 0.50. 

The Sahm rule stands at 0.43, according to data from the St. Louis Fed. A tick in the unemployment rate in July to 4.2% from 4.1% in June would trigger the indicator.  

Many economists are already brushing off the potential recession warning. Sahm herself has said the rule, with a near-perfect history, may not be accurate this time because “the swing from labor shortages caused by the pandemic to a burst in immigration is magnifying the increase in the unemployment rate.”

Economists at Goldman Sachs similarly say they are not so worried about the rise in the jobless rate, which in June rose to the highest level since November 2021. The main reason: A rising unemployment rate is normally accompanied by rising layoffs, but that isn’t currently the case. They say the increase in the unemployment rate has instead come partly from a surge in labor supply driven by immigration.

The official data appear to back up Goldman’s point. The four-week moving average for initial filings for unemployment insurance is 235,500, up 10% from three months ago but exactly even with the comparable week a year ago and nearly identical to the average over the five years leading up to the Covid-19 pandemic. 

Relatively low and stable initial filings for unemployment insurance have puzzled analysts suspicious of robust establishment payroll gains, regularly revised lower and at odds with much weaker household employment. But assumptions about historically low layoffs and immigration’s effect on unemployment may be more flawed than even skeptics have appreciated.   

Colby College professor Kathrin Ellieroth and Minneapolis Fed economist Amanda Michaud in a July paper identify a meaningful problem in job-market data that vastly overstates voluntary quits and understates layoffs. The duo developed a way to distinguish between quits or layoffs for flows from employment to what they call non-participation–or a full exit from the labor market, as opposed to unemployment. 

Labor-force exits have previously been categorized as voluntary quits, but Ellieroth and Michaud find that over 40% of all flows into non-participation are actually precipitated by layoffs. They add that the unemployment rate is slow to increase during recessions because the first wave of layoffs target those that will exit the labor force. 

The distinction is critical given that rising quits imply labor-market strength while rising layoffs suggest the opposite. The finding helps square seemingly low jobless claims with a rising unemployment rate. 

Here is another point worth mentioning. Ellieroth and Michaud note that both quits and the share of laid off workers exiting the labor force are procyclical, meaning labor supply increases in recessions. That idea makes it worth questioning whether some analysts and investors have gone too far in attributing rising labor supply to immigration and are thus too quick to disregard the rising unemployment rate as more a quirk than a problem. 

Now consider some research this week from investment management company Verdad Advisers. Analysts there say they have been focused on studying how macroeconomic signals can help predict expected returns across asset classes. To find the right analogues, they created what they call a measure of macroeconomic similarity using a range of economic signals including high-yield spreads, inflation, and the yield curve. 

The researchers then converted the economic data at each point into a vector, or a multi-dimensional mathematical object that represents a list of data points in a specific order. To measure how extreme each observation is, they calculated the distance between that vector and all historical vectors going back to 1960. The smaller the distance between two months of data, the more similar those moments are, and vice versa.  

Verdad found that today’s market conditions are most similar, in reverse chronological order, to the following eight periods: 2019, 2007, 2000, 1995, 1989, 1979, 1973, and 1969. They note that those periods were generally defined by conditions that encourage risk taking, such as tight high-yield spreads that lead to high-risk borrowing, subdued volatility that encourages leverage, and an inverted yield curve which means long-duration government bonds are less attractive.

The worrisome thing, they researchers note, is that four of the eight closest analogous periods preceded major market crashes within 12 months. Verdad highlights the 50% hit rate for negative forward 12-month S&P 500 returns and a negative average return over all eight analogues as impressive considering the S&P 500 has averaged a 9% annual return from 1969 to 2024.

Verdad acknowledges that their findings alone don’t mean we are on the precipice of the next great financial crisis. “But we do think this provides a more data-driven way to think about the macroeconomic climate than narratives drawn from cable news—and, in this case, the data seems to tell quite a different story than the popular narrative,” they say.  

The prevailing narrative will eventually change, but not until lagging data piles up and flawed assumptions are debunked.