If the rise in unemployment in the US does not lead to a recession, we have an exception that proves the rule

Global stock markets marked the beginning of August with the largest fluctuations in stock prices this year. Starting from Friday, August 2, and concluding on Monday, August 5, the three main US stock indices (Nasdaq Composite, S&P 500, and Dow Jones Industrial Average) recorded the largest drop since June 2022. Additionally, the group known as the ‘magnificent seven’, or the seven most lucrative companies in the technology sector, which has been the main driver of stock indices to record values this year, lost about 800 billion dollars in market value on Monday.

It is worth mentioning that even the strong three-day sell-off of stocks did not push those stocks into the negative when looking at their price since the beginning of the year. Many investors were concerned about Nvidia on that first Monday of the month, whose stock price fell by as much as seven percent, but it was still worth almost double what it was at the beginning of this year. In simple terms, although market uncertainty was extremely high, this three-day price plunge did not significantly affect the overall performance of US stock indices this year.

More regularity than a rule

The real question now is why this correction occurred on US stock markets, which, as expected, also pulled down stock prices on all other major global stock markets. For most of this year, it seemed that the US central bank, the Federal Reserve (FED), was successfully managing inflation by raising its benchmark interest rates to the highest level in the last two decades and planning a so-called soft landing. However, a disappointing report on the US labor market released on August 2 showed that the unemployment rate rose for the fourth consecutive month in July, to the current 4.3 percent, the highest unemployment level in the US since October 2021. This also represents an increase of almost a full percentage point from the lowest level recorded in January last year, which is why many began to refer to the so-called Sahm rule, invoking a recession for the largest economy in the world.

This rule is named after economist Claudia Sahm, who discovered the causal link between rising unemployment and recession. She claims that a recession occurs if the three-month moving average of the national unemployment rate rises by 0.5 percentage points above its previous 12-month minimum. The rule has never given a false result so far. However, it might now. The labor market in the US has been returning to normal for three years after the disruptions caused by the pandemic outbreak when in April 2020 the unemployment rate jumped from 3.2 percent (the lowest in the last five years) to 15 percent. Therefore, some today interpret that the labor market is actually returning to normal after the pandemic and that the Sahm rule may not be accurate at the moment. The problem for the rule is also the surge in immigration. All of this was commented on by domestic economist Ivica Brkljača.

– The Sahm rule is not a rule in the full sense of the word. It is more, as Claudia Sahm herself says, statistical regularity that she discovered. Now, how wise it is to just wave it off, seeking explanations that the current rise in the unemployment rate is a result of the growth of the labor force, i.e., significant (and) illegal immigration, rather than large layoffs, is debatable. Maybe this time it is indeed different, but if the Sahm rule has ‘predicted’ a recession every time so far and has never given a false signal, then it carries some weight, says Brkljača.

A correction had to happen

It would certainly be hasty to raise panic and call for a recession without looking at other economic indicators that burst with optimism. In the second quarter of this year, the US economy accelerated its growth thanks to stable personal consumption and a strong recovery in exports, recording a GDP growth of 2.8 percent compared to the same period last year. Compared to the first quarter, activity increased by 0.7 percent. Personal consumption rose by 2.5 percent in the second quarter, and exports jumped by 3.5 percent. Thus, economic activity is flourishing while the labor market cools, but this cooling could still be a consequence of the FED’s high interest rates.

– High interest rates act precisely to dampen economic activity in order to bring the inflation rate to the desired level. The problem is that the FED’s moves have a significant time lag on economic activity, and it is difficult to determine how long that lag is. Estimates vary from six to 24 months. Therefore, there is some concern that the FED has kept interest rates above five percent for too long, and that the full effect of this will only be visible in the coming quarters. The FED will almost certainly start cutting interest rates as early as next month, despite not having reached the targeted inflation, says Brkljača, adding that the FED, unlike most other central banks, has a dual mandate and that maintaining full employment is as important to it as low inflation.

– These two goals are occasionally opposed, so the next period will be extremely challenging for the US central bank as it will seek a middle ground, trying to prevent further deterioration of the labor market while not reigniting inflationary pressures, concludes Brkljača.

Let us now return to the beginning of the story and the drop, or correction, in the stock markets. After the correction, many analysts, commentators, journalists, and investors rushed to explain that some correction had to happen because, as confirmed by the director of Fima Plus Milan Horvat, after a longer period of growth, it is quite normal for stock prices on the markets to correct.

– We had an almost identical scenario in April and early May when a correction occurred in the US before the report for the first quarter, albeit of lesser intensity, because this, in addition to the standard cashing in of profits, was intensified by a sudden sale of positions bought based on the leverage of the cheap Japanese yen. The impetus is always some data that in such a constellation triggers an avalanche that is essentially just waiting to be triggered because prices have gone too high due to positive sentiment. Without that, the data would not have that power. For now, there is no data that unequivocally confirms that the US is sliding into a recession, except for a lot of speculation from the usual doomsayers, comments Horvat.

Well, the markets corrected, and just four days after the ‘drop’, they recovered almost all their losses. The latest data from the US Department of Labor that the number of unemployment claims fell to 233 thousand, which is 17 thousand less than the previous week and below analysts’ expectations, provided grounds for new optimism and pushed fears of recession to the background.

Seeking a new balance

The whole situation is also pressuring the FED to start easing its strict monetary policy so that the largest economy in the world does not slip into a major crisis, but Horvat still tells us that the interest rate does not cause either the beginning or the end of a crisis.

– It balances and equalizes relations within each economy, including the American one. For example, large technology, but also other, large-cap corporations are mostly highly liquid and profitable, especially those with a technological background, as they easily introduce artificial intelligence into their regular operations, thus increasing business efficiency. Higher interest rates are not a problem for them, and therefore these companies carried stock market gains during the period of high FED rates aimed at combating inflation. Small and medium-sized companies are not so successful and depend more on the cost of capital, so the announced reduction in rates will make life easier for them in financing working capital and development. This will achieve a balance that has been disrupted by the fight against inflation, concludes Horvat.