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Recent softness in US economic data – especially from the labour market – has reignited investor concerns about the potential for a recession in the world's largest economy.

For this month’s CIO Insights, we dug into the data to understand the risk of a downturn. Our take: the odds of the US tumbling into a deep recession in the near term are still relatively low. What’s more, uncertainty surrounding the upcoming presidential election could be injecting additional noise into markets. 

Key takeaways: 

• Softer labour data does not mean a US recession is certain. While a popular recession indicator known as the Sahm rule was triggered in July, a closer look at the underlying drivers suggest that rising unemployment is also being driven by stronger labour supply rather than a weakening in demand. Temporary factors, like the impact of Hurricane Beryl, may have also affected the latest US jobs report. A big picture view suggests the labour market is cooling but not necessarily collapsing.
• Other forward-looking indicators also suggest a recession isn’t imminent. On top of the potential noise in recent data, the unemployment rate is a lagging economic indicator. We’ve reviewed a broader set of forward-looking indicators – from CEO confidence to financial stress – and from these we also conclude that an imminent US recession is unlikely.
• Election-related uncertainty may also be contributing to softer economic data. Commentary from manufacturers suggest that companies are holding off on spending ahead of the election. In addition, markets have historically been more volatile in the period leading up to presidential elections, and normalised once the outcome was certain. That said, any contest of the election results poses the risk of continued uncertainty for firms and markets. 
• A manufacturing recovery could continue post-election, providing support for company earnings. As companies gain more certainty on the outlook for economic policy after the election, we expect the recovery in the manufacturing sector – which we discussed in our Mid-Year Outlook – to continue. The start of interest rate cuts from the Federal Reserve (Fed) is another positive, as it reduces the burden on businesses and households.
• Put together, the next few months could be choppy for markets. The potential for softer economic data – and heightened market sensitivity to that data – could lead to elevated market volatility in the months leading up to the election. 
• No matter the economic environment, there are ways to stay invested. Our Economic Regime Asset Allocation (ERAA®) investment framework shows that we remain in an environment of “Inflationary Growth”. This backdrop presents a good opportunity for long-term investors to move allocations from cash into equities or higher-yielding bonds. 

The US labour market is cooling, but it’s still too early to say a recession is looming 

The market correction at the start of August was partly due to a disappointing US jobs report for July, which showed an unexpected increase in the unemployment rate and a marked slowdown in employment gains. That contributed to expectations of a more rapid pace of rate cuts from the Fed and a further unwinding of the “carry trade”. (Read more on that here: Message from our CIO: Understanding the recent market correction.)

The market is rightfully worried, as a rising jobless rate has historically tended to coincide with recessions. Investors have been citing the Sahm rule – an indicator that tracks the rise in unemployment, with a good track record of signalling the start of past recessions – which was triggered in July. (See the Glossary at the end of this article for a more detailed explanation of this and other key terms.) 

However, before concluding that a recession is inevitable, we offer a few points:

1. Increasing labour supply has been driving the rise in unemployment 

When asked about what the Fed thinks about the Sahm rule, Chair Jerome Powell called it a “statistical regularity”. Indeed, it’s important to remember that the rule is a statistical observation – while it has been successful in identifying past patterns,, there is no fundamental economic theory that guarantees it would be able to predict future ones. 

In fact, Claudia Sahm, the former Fed economist after whom the Sahm rule is named, has written extensively on some of the differences between the current situation and past triggers. Most notably, Sahm argues that stronger labour supply – due to increased immigration, for example – has accounted for a large part of the increase this time around. That’s unique from previous episodes, which were largely driven by weakening labour demand.

Finally, as illustrated in the chart below, the slope of Sahm’s indicator has been much more gradual compared with previous times when the rule has been triggered. This is consistent with an increase in the labour supply being a key driver of unemployment, rather than a sharp deterioration in demand.

2. July’s labour market weakness could be tied to one-off events

While the July jobs data was weak, it could have been distorted by one-off events like Hurricane Beryl, which hit the southern US in early July. 

More than 400,000 people reported that they weren’t at work due to bad weather during the month, or 10 times the average for the month of July. Temporary layoffs – some of which were likely also related to the hurricane – accounted for more than half of the increase in the number of unemployed people. 

More recent data like the weekly jobless claims figures for August, on the other hand, have also shown more resilience.

3. Unemployment is rising, but from very low levels

Even if a recession were on the horizon, it would likely be shallow. The unemployment rate, at 4.3% as of July, is rising from very low levels, with the measure hitting a multi-decade low of 3.4% last year.

As shown in the chart below, during past recessions when the unemployment rate saw a trough below 4% (like those in 1953-54, 1969-70, 2001, and most recently, 2020) the downturns that followed were relatively mild. 

In short, it’s not just the change in unemployment that matters, but also the level. So rather than a collapse, the current data point to a cooling in the labour market and the economy as a whole.

Forward-looking data suggests the economy is still holding up 

On top of the potential noise in the recent data, unemployment is also a lagging indicator; it’s often considered the “last shoe to drop” before an economic downturn. 

What are other high-frequency and forward-looking indicators saying? In general, they also suggest the economy is still holding up:

• A swathe of high-frequency data on consumption and industrial traffic show that consumers are still spending and goods are still moving across the global economy at a relatively healthy pace.

• The Conference Board’s survey of multinational CEOs still points to a cautiously optimistic view of the economy, with most not anticipating a US recession.

• On the other end of the spectrum, the National Federation of Independent Business’ survey of small businesses shows optimism has been rising and now back to early-2022 levels.

• The Atlanta Federal Reserve’s GDP “nowcasting” model suggests the economy is still running at a steady clip of around 2% annualised growth as of mid-August.

• Finally, Goldman Sachs’ Financial Stress Index shows that levels of financial stress are still within a normal historical range. This suggests that the recent market volatility has had limited pass-through to the broader economy.

Election uncertainty may contribute to soft data, market volatility

Looking ahead, we believe that uncertainty tied to the US election may also result in softer economic data. The most recent Purchasing Managers’ Index (PMI), for example, showed that business conditions among manufacturers deteriorated for the first time since December as orders slowed. 

The commentary from S&P Global highlights that this weakness is ”linked to paused spending and investment ahead of the Presidential Election,” and may be temporary. The uncertainty over tax and regulatory policies that could come from the next administration is prompting businesses to hold off on their plans in the coming months.

So while small businesses may be increasingly more optimistic, the chart below illustrates that they are also becoming increasingly more uncertain about the policy environment – a similar trend to previous presidential election years.

Similarly, markets have also tended to be more volatile in the months leading up to US elections – especially so when there is a considerable amount of uncertainty over the results. However, that volatility tends to stabilise after the results are in and there is more certainty over the trajectory of economic policy and its impact on markets. 

Given the changes in the political landscape over the past few months, we expect this pattern will also apply to this election cycle. That said, any potential contest over the election results does pose the risk of continued uncertainty for firms and markets. 

A manufacturing recovery could regain momentum in the months ahead

Looking further forward, we believe that a recovery in manufacturing growth may resume post-election as the economic outlook becomes more certain. In addition, the start of the Fed’s rate cutting cycle in the coming months should ease financial pressures on households and businesses.

As we discussed in our Mid-Year Outlook, the manufacturing cycle is closely linked to the corporate earnings cycle. Indeed, in line with that recovery in manufacturing, growth in corporate earnings per share (EPS) have turned positive in recent months on both a trailing 12-month and forward 12-month basis, as shown in the chart below. Positive earnings growth is consistent with an economy that’s still in relatively good health.

The US election could contribute to choppy markets, but it’s important to keep the fundamental cycle in mind 

Put together, the data suggest that a US recession is not likely in the near term – though the upcoming US election may introduce some noise to both the markets and the macroeconomic data in the period ahead. 

That suggests that the coming months could be choppy for markets given the potential for softer economic data and greater investor sensitivity around that data. (For more on how US elections have impacted markets, see CIO Insights: The winning strategy for elections? Stay invested.)

That said, it’s important to keep the bigger picture in view and remember where we are in the economic cycle. Signals from our Economic Regime Asset Allocation (ERAA®) investment framework show that we remain in a regime of Inflationary Growth. This environment presents an opportunity for longer-term investors to move their allocations from cash and cash equivalents to riskier assets like equities or higher-yielding bonds – which is how we’ve positioned our ERAA-managed portfolios.

Lastly, as the markets are likely to remain volatile in the coming months, it may be tempting to try to time it. Instead, we recommend investing consistently – via dollar-cost averaging into a well-diversified portfolio – to capture any market corrections as they come. Staying invested across various market conditions tends to smooth out volatility, and opens up opportunities for you to benefit from price dips. When it comes to long-term investing, keep calm, stay the course, and let time be your ally.

Glossary

Sahm rule 

A statistical indicator developed by former Federal Reserve economist Claudia Sahm. The rule asserts that if the three-month moving average of the unemployment rate increases by 0.5 percentage points or more from its lowest level in the previous 12 months, it is a signal that a recession has likely begun.

Forward-looking/lagging data

Economic indicators that help predict future trends (forward-looking) or confirm past trends (lagging). Forward-looking data, like consumer confidence or business orders, signal upcoming economic activity. Lagging indicators, such as unemployment rates or corporate profits, reflect past economic activity.

High-frequency data

Economic information collected and reported more frequently, often daily or weekly. Examples include credit card transactions or weekly jobless claims, which provide more immediate economic insights.

“Nowcasting”

A method of estimating the current state of the economy using real-time data. Like forecasting, but for the present rather than the future, providing a current snapshot of economic conditions.

Financial Stress Index

A composite measure that tracks the overall stress level in financial markets. It typically combines various indicators like volatility, bond spreads, and banking sector health.