Bad news is bad news again
A number of dynamics were at play during the recent equity selloff and bond rally, from disappointing corporate earnings reports to market positioning, but we think growing concern about the health of the U.S. labor market was central to this recent bout of volatility.
The surprise jump in the jobless rate in July wasn’t exactly an outlier as far as data misses go, and most have been taken in stride to this point. Cooling in the U.S. labor market was previously seen by investors as a positive development—a “bad news is good news” dynamic—as it would allow the U.S. Federal Reserve to gradually lower interest rates and relieve pressure on businesses and households.
But with unemployment trending higher and the Fed yet to budge from its restrictive stance, there is increasing concern among investors that the central bank’s monetary policy is behind the curve and it’s too late to prevent a further rise in the jobless rate. You know “bad news is bad news” again when a disappointing jobs report leads to calls for policymakers to make an emergency, inter-meeting rate cut.
“Rules are made to be broken”
Adding to the handwringing, the upside surprise in July’s unemployment rate triggered the Sahm Rule, a reliable recession indicator that investors have been keeping a close eye on. The Sahm Rule, named after Claudia Sahm, a macroeconomist who worked at the Fed, states that “when the three-month moving average of the national unemployment rate is 0.5 percentage point or more above its low over the prior twelve months, we are in the early months of recession.”
The math sounds a bit convoluted (it was dreamed up by an economist, after all) but it essentially says that, historically, when the jobless rate increases meaningfully in a one-year period, it doesn’t tend to stop there. When the Sahm Rule has been triggered in the past, the unemployment rate has gone on to increase by at least two percentage points from its cycle lows and the U.S. economy has experienced a recession.
But the Sahm Rule was never meant as a recession predictor, and Claudia Sahm herself calls it “a historical pattern, not a law of nature.” She adds that “rules are made to be broken” and if her eponymous rule is to break, this unusual post-pandemic cycle could be the occasion.
Indeed, there are reasons to think this time is different. The current unemployment rate is the lowest at which the Sahm Rule has been triggered since 1953. Thus far, the U.S. labor market has simply eased from previously tight levels to conditions that could still be characterized as consistent with “full employment.” Despite rising joblessness, there continue to be more vacancies than unemployed persons.
The concern, though—and the dynamic captured in the Sahm Rule—is that layoffs will beget more layoffs as a precautionary pullback in consumer spending causes businesses to reduce headcount. But as RBC Capital Markets points out, the Sahm Rule has been triggered without the usual increase in job losses. At this point, the rise in unemployment has been driven more by new entrants into the labor force having difficulty finding a job, resulting in a loss of potential income rather than actual income.
The Sahm Rule has been triggered without the usual increase in jobless claims
Change in initial jobless claims (thousands) between unemployment rate low and Sahm Rule trigger
The line chart shows the change in the weekly U.S. unemployment rate for nine periods, each of which begins with a low point in the unemployment rate and ends with the triggering of the Sahm Rule. In all previous periods (1970, 1974, 1980, 1981, 1990, 2001, 2008, and 2020), the change in jobless claims was largely positive, and followed a generally upward trend. In 2024, however, the change remained negative for more than 50 weeks until the Sahm Rule was triggered.
*UER stands for unemployment rate.
Source - RBC Capital Markets
Consumer spending has held up thus far and there are few signs of an increase in precautionary savings as households brace for a slowdown. The Q2 earnings season saw some management teams express concern about the health of the U.S. consumer. But with the economy growing by 2.8 percent in Q2 and the Atlanta Fed tracking a similar increase in Q3, we think there’s reason to doubt we’re in the early months of a recession.
Sahm story in Canada?
Sahm proposes a similar rule for Canada using a slightly higher 0.6 percentage point trigger for the increase in the unemployment rate. But the Canadian version doesn’t have as spotless a record as in the U.S., which could be why it attracts less attention. There was little fanfare when it was triggered late last year, and certainly no calls for an emergency rate cut by the Bank of Canada.
Layoffs account for a larger share of the increase in unemployment compared with the U.S., but other factors are also at play in Canada. In the two years since Canada’s unemployment rate troughed, students entering the labor force and failing to find a job have accounted for as much of the increase in unemployment as have permanent layoffs.
Immigration has boosted Canadian labor force growth to an even greater degree than in the U.S. But the economy has had difficulty creating enough jobs to absorb all of these new entrants, and nearly half of the increase in unemployment has been among recent immigrants and non-permanent residents.
Unlike in the U.S., Canada’s household savings rate is trending higher and consumer spending has been sluggish, slowing on a per capita basis over the past two years. Canada has avoided two consecutive quarterly declines in headline GDP but could be said to be in a “per capita recession” with population-adjusted GDP down more than 3.5 percent from its cycle highs. A 1.6 percentage point increase in the unemployment rate from its cycle lows is also consistent with past “mild” recessions.
It pays to be defensive
Unusual post-pandemic labor market dynamics leave room for hope that this time will indeed be different. But leaving room for hope is much different than positioning entirely for a soft landing, and we think some of the recent financial market volatility reflects investors in the latter camp being caught by weaker-than-expected economic data.
Whether the current period will prove to be a growth scare or the early stages of a recession is still unknown. But we think investors should evaluate defensive options in their portfolios, as advocated in the August Global Insight. We recently examined some of the nagging questions facing equity markets and suggested holding no higher than a Market Weight position in U.S. and global equities.
While fixed income has rallied amid deteriorating economic data and growing rate cut expectations, current yields remain attractive relative to much of the past two decades. Tight corporate bond spreads mean investors are receiving limited compensation for taking on credit risk, leading us to favor higher-quality corporate and government bonds. In our assessment, investors who haven’t already taken the opportunity to add some duration and lock in today’s high yields for longer should consider doing so on market pullbacks.