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, LOIM. 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, LOIM. 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, LOIM. 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.

 

---

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: LOIM’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.

For professional investors use only

This document is a Corporate Communication and is intended for Professional Investors only. 

This document is a Corporate Communication for Professional Investors only and is not a marketing communication related to a fund, an investment product or investment services in your country. This document is not intended to provide investment, tax, accounting, professional or legal advice.

This document is issued by : 

Lombard Odier Asset Management (Europe) Limited (hereinafter the “Company”). The Company is authorised and regulated by the Financial Conduct Authority (the “FCA”), entered on the FCA register with registration number 515393. 

This document is approved at the date of the publishing. The Company is clustered within the Lombard Odier Investment Management Division (“LOIM”) of Lombard Odier Group which support in the preparation of this document and LOIM is a trade name.

Any opinions or forecasts provided are as of the date specified, may change without notice, do not predict future results and do not constitute a recommendation or offer of any investment product or investment services.

This document is the property of LOIM, is provided for information purposes only and is addressed for the recipient exclusively for its personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. It is not intended for distribution, publication, or used for any other purpose without the prior written permission of LOIM. 

The contents of this document are intended for persons who are professionals and who have been vetted by LOIM and assessed as suitable to the investment matters set out in this document and in respect of whom LOIM has received an assurance that they are capable of making their own investment decisions and understanding the risks involved in making investments of the type included in this document or other persons that LOIM has expressly confirmed as being appropriate recipients of this document. If you are not a person falling within the above categories, you are kindly asked to either return this document to LOIM or to destroy it and are expressly warned that you must not rely upon its contents or have regard to any of the matters set out in this document in relation to investment matters and must not transmit this document to any other person. This document contains the opinions of LOIM, as at the date of issue or completeness of the information contained in this document, nor does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice.

The contents of this document has not been reviewed by any regulatory authority in any jurisdictions and does not constitute an offer or a recommendation to subscribe for any securities or other financial instruments or products.   

It contains opinions of LOIM, as at the date of issue. These opinions and information contained herein in this document does not take into account all the specific circumstances of the addressee. Therefore, no representation is made that the information presented in this document are suitable or appropriate to the individual circumstances of any investors. Tax treatment depends on the individual circumstance of the investor and may be subject to change in the future. LOIM does not provide tax advice. 

The information and analysis contained herein are based on sources believed to be reliable. While LOIM uses its best efforts to ensure that the content is created in good faith and with greatest care, it  does not guarantee the timeliness, accuracy, validity, reliability or completeness of the information contained in this document, neither does it warrant that the information is free from errors and omission not does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice. Particular contents of third parties are marked as such. LOIM assumes no liability for any indirect, incidental or consequential damages that are caused by or in connection with the use of such content. 

The Source of the data has been mentioned wherever it was available. Unless otherwise stated, the data is prepared by LOIM. 

Not for US Person: This corporate communication is not intended for any "U.S. Person" as defined in Regulation S of the Act, as amended or pursuant to the 1940 United States Investment Company Act as amended and will not be registered pursuant to the 1940 United States Investment Company Act as amended, or pursuant to other US federal laws. Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
 
Data Protection: You may be receiving this Communication because you have provided us your contact details. If this is the case, note that we may process your personal data for direct marketing purposes. For more information on Lombard Odier’s data protection policy, please refer to www.lombardodier.com/privacy-policy 
 
©2024 Lombard Odier IM. All rights reserved.