Is 4.1% Unemployment a Recession Warning?

Hello, and welcome to Notes on the Week Ahead, a JPMorgan Asset Management podcast that provides insights on the markets and the economy to help you stay informed in the week ahead. Hello, this is David Kelly. I'm Chief Strategist here at JPMorgan Asset Management. Today is July 8th, 2024.

Despite a slightly higher than expected payroll job gain, the June employment report was on the soft side, with down revisions to payroll gains from prior months, a drop in temporary employment, and only modest gains in wages. However, the weakest aspect of the report was the unemployment rate, which had edged up from 4.0% to 4.1%.

Now, this in itself wouldn't be particularly notable, were it not for the fact that the unemployment rate has now risen steadily over the past 14 months from a 54-year low of 3.4% set in April of last year. Historically, a significant rise in the unemployment rate from a cyclical low has been a warning sign of imminent recession and can be added to others such as a falling index of leading economic indicators or an inverted yield curve that have been predicting recession for some time.

On balance, we still don't think recession is just around the corner. However, a rise in the unemployment rate provides further confirmation that economic momentum has has downshifted to a lower gear, suggesting a need for increased vigilance by investors in making sure portfolios are not too exposed to an economic downturn. The Business Cycle Dating Committee of the National Bureau of Economic Research has a responsibility for declaring when the U.S. economy enters and exits a recession.

They define a recession as being a significant decline in economic activity that has spread across the country and lasts more than a few months. In evaluating economic activity, they look at real retail and wholesale sales, industrial production, real personal income apart from transfers, real consumer spending, and employment as measured by both the household and payroll surveys.

Unfortunately, many of these data are published with a lag, and the committee usually takes many further months before announcing that the economy has entered or exited recession. For both investors and policymakers, it would be nice to have a simpler rule or indicator to provide a heads-up that recession is imminent.

For many years, the best-known rule of thumb was that when the Index of Leading Economic Indicators, which is now compiled by the Conference Board, fell for three consecutive months, the economy would shortly slip into recession. However, the index has now fallen steadily since December 2021 without any recession materializing.

This indicator appears to be broken, both because of an overemphasis on manufacturing in an increasingly service-dominated economy and because of problems with index construction that have added a downward bias to monthly numbers. Another rule was an inverted yield curve, defined in this case as three-month treasury bill yields being higher than 10-year treasury bond yields, signaled a recession starting within a year.

However, by this measure, the yield curve has now been inverted for 20 straight months, with, again, no sign of imminent recession. The failure of this recession predictor may simply be due to a decline in the impact of interest rates and aggregate demand, or a side effect of significant Fed operations impacting the long end of the bond market.

A third rule based on the unemployment rate has been proposed by Federal Reserve economist Claudia Sam as a way to be relatively sure the economy was in fact slipping into recession. Sam suggested that this rule could be used as an automatic trigger for stimulus payments rather than waiting on the analysis and deliberation of economists and policymakers in determining the start of a recession and deciding what to do about it.

The Sam rule says that the economy is entering a recession when a three-month moving average of the unemployment rate has risen by at least five-tenths per percent above the minimum three-month average seen over the prior 12 months. Retrospectively, it has provided a pretty accurate signal of recession.

The SAM rule would have been triggered in all 12 of the recessions seen in the United States since 1947, albeit with the signal kicking in on average three and a half months after the recession had started. Moreover, there have been only two brief instances in late 1959 and mid-2003 when the rule implied a recession that didn't actually transpire.

It should be noted that the SAM rule was not triggered by Friday's June jobs report, since although the unemployment rate is 7 tenths of a percent above its minimum for this expansion, the three-month moving average of the unemployment rate is only 4 tenths of a percent above the minimum three-month moving average over the 12 months ended in May.

However, if the unemployment rate were to edge up by just one-tenth of 1 percent over the next few months, from 4.1 percent to 4.2 percent, the economy would be, according to the SAM rule, entering recession.

Given our proximity to a recession signal from the unemployment rate, it's worth asking, what exactly is boosting the unemployment rate? First, looking at other economic data suggests that it is not due to a general slowdown in aggregate demand. Real GDP grew by an above-trend 2.9% in the year that ended in the first quarter, hardly a sign of a faltering economy. Now, it is true that annualized growth in the first quarter was just 1.4%, and we expect about 2% growth in the second.

However, GDP growth impacts employment with a lag, so this recent downshift shouldn't be responsible for rising the unemployment rate over 14 months. The rise probably can't be blamed on surging immigration either. As we've mentioned before, we do think that rising immigration has prevented the unemployment rate from falling further. However, this likely just offset chronic weakness in labour force growth among the native-born population.

It's worth noting that the unemployment rate among immigrants is essentially the same as among the native-born population, so the fact that immigrants have dominated labour force growth shouldn't in itself have boosted unemployment rates. It should also be recognised that six states with the fastest growth in unemployment rates in the year ended in May, were Rhode Island, Washington State, Connecticut, Ohio, Oregon, and Maryland, none of which were on the front line of the immigration surge.

So if it's not collapsing demand or surging immigration, what has boosted the unemployment rate? The answer may be more microeconomic than macroeconomic, and probably stems from the nature of the superheated labor market in April 2023, when the unemployment rate fell to its cyclical low of 3.4%. At that time, there were still 9.9 million job openings, despite payroll job gains over the prior year averaging $320,000 per month.

Wages are up 4.7% year-over-year. While all these numbers were lower than their cyclical peaks, the reality is that it was very easy to find a job and businesses were hiring furiously. But in such a labor market, both businesses and workers can be a little too optimistic. Some people may have been hired who simply did not have the skills or work habits to do the job. Equally, some people may have tried to add a job to a hectic lifestyle that just couldn't be sustained.

Two pieces of evidence seem to support this idea. First, between April 2023 and June 2024, while the number of people unemployed for less than 15 weeks rose by 261,000 or 14%, the number unemployed for more than 15 weeks climbed by 766,000 or 42%.

In an economy with still over 8 million job openings, this climb in long-term unemployment suggests that there are many workers who, who in anything other than a frenzied job market just have a hard time getting hired or holding down a job when they do get hired. Second, between April 2023 and June 2024, according to the Household Survey, the number of part-time workers rose by 912,000, while the number of full-time workers shrank by 675,000.

Both of these numbers are very likely underestimates due to faulty population counts produced by the Census Bureau. However, the trend towards more part-time employment is likely genuine. Part-time workers tend to have higher unemployment rates than full-time workers, and strains related to daycare, transportation, illnesses, and shifts that just don't work out may be leading to more unemployment among this group.

In other words, some of the move back to a roughly 4% unemployment rate may just reflect the reality that while in a white-hot jobs market, both employers and employees can make optimistic plans, in the long run there are some workers whose skills and circumstances will leave them unemployed for some of the time in a normal economy.

If this perspective is correct, then the recent rise in unemployment doesn't suggest imminent recession and wouldn't, even if the SAM rule is triggered by a further small increase in unemployment rate next month.

However, the rise in the unemployment rate has occurred at a time when payroll job growth and real GDP growth appear to be slowing. Consumer spending on non-durable goods is also slowing, while credit card and auto delinquency rates are rising. All of this suggests that the economy is downshifting to a lower gear, and we now expect that real GDP growth, which was of 3% in the year ended in the fourth quarter of last year, will be between 1.5% and 2% by the fourth quarter of this year.

This downshift in growth, combined with further moderation in inflation, which should be visible in this week's CPI report, gives the Fed ample grounds for beginning an easing cycle in September, a move that would generally be welcomed by markets. However, it does also make the economy a little bit more vulnerable, increasing the risk that some shock could trigger a recession.

Because of this, while neither 4.1% unemployment nor other leading indicators suggest a quick end to this expansion, investors should make sure that their portfolios are sufficiently balanced to weather such a possibility. Well, that's it for this week. Please tune in again next week, and if you have any questions in the meantime, please reach out to your J.P. Morgan representative.

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