by Paul Hoffmeister, Portfolio Manager and Chief Economist
The “Sahm Rule” has been triggered, suggesting that the US economy might already be in recession.
Upcycles in unemployment can have significant momentum. During previous episodes since 1970 when the Rule was triggered, the unemployment rate has increased by a median of 1.6 percentage points twelve months later. This implies that today’s unemployment rate of 4.3% may increase to 5.9% by next summer.
Upturns in unemployment like we’re seeing today have historically correlated with recession and weak equity markets.
It’s possible that the US economy is now in recession, at least according to the “Sahm Rule”, an obscure economic signal.
The Sahm Recession Indicator, named after former Federal Reserve economist and current Chief Economist at New Century Advisors Claudia Sahm, “signals the start of a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months." (St. Louis Federal Reserve Bank)
In terms of the headline numbers, the unemployment rate jumped more than expected in July to 4.3%, which is a significant increase from 3.7% at the beginning of the year and from 3.5% in July 2023. (Bureau of Labor Statistics) From the perspective of the Sahm Recession Indicator, the current three-month moving average has increased by 0.53 relative to the low in that moving average during the last year; and as a result, the Indicator suggests that a recession in the United States has likely already begun.
We won’t know for a while if the economy is officially in recession today. It takes many months for the National Bureau of Economic Research (NBER) to officially declare any recession start dates. And, of course, there’s no guarantee that the Sahm Rule is correct right now. Even Claudia Sahm herself has recently cautioned: past performance is no guarantee of future results.
In fact, she isn’t convinced that the Rule is correct this time, although the jump in unemployment is “disconcerting.” As she sees it, the increase in the unemployment rate may be more due to an increase in labor supply rather than weakening labor demand, and if so, it’s possible that the US economy is not yet in recession.
Notwithstanding, the Sahm Rule has a good track record that must be considered. Every time that it has been triggered since 1970, it has been correct in signaling the beginning of recession.
If anything, the recent triggering of the Sahm Rule is a warning to policymakers at the Federal Reserve. As investors, our biggest concern is the momentum that a rising unemployment rate can have. Quite simply, during economic downturns, unemployment tends to rise for a while.
After analyzing the Sahm Rule and the unemployment data since 1970 (and excluding the unique Covid pandemic experience), we have found that once the Sahm Rule is triggered (i.e. its level exceeds 0.50 for the first time in an economic cycle), the unemployment rate increases twelve months later by a median of 1.6%. This would mean that the current unemployment rate will possibly increase to 5.9% by next summer.
Chart of the 3-month/10-year Treasury spread (dotted white line), core PCE year-over-year inflation (orange line), and the U.S. unemployment rate (white line); recession periods highlighted in red. Source: Bloomberg.
This outlook is quite different from the Fed’s forecasts. In their June projections, the median expectation among Federal Reserve Board members and Federal Reserve Bank Presidents was that the unemployment rate would be only 4.2% by year-end 2025.
The historical record of rising unemployment after triggering the Sahm Rule is just another reason why we believe that the Fed is currently behind the curve. But even more, we’re concerned that worsening employment will lead to weaker equity markets. In the past, an environment of persistently rising unemployment tends to correlate with a slowing economy, slowing earnings growth, and generally falling stock prices. Indeed, as the chart above illustrates, during the last 35 years, each upcycle in unemployment was associated with both recession and weak stock indices.
In sum, we view the recent triggering of the Sahm Rule and the recent jump in the unemployment rate as additional data points -- alongside the inverted yield curve, weak leading economic indicators and many other indicators -- that an economic recession is on the horizon, if not already here. Based on the historical evidence, we expect this year’s increase in unemployment to continue and in so doing will lead to further economic and equity market weakness.
Paul Hoffmeister is Chief Economist and Portfolio Manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors (CEDA), and co-portfolio manager of the Camelot Event-Driven Fund (EVDIX • EVDAX).
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