Unemployment, Recessions, and the S&P 500

Last month, we explained that interest rates were expected to stay higher for longer because inflation had become stubborn. Core PCE was holding near 2.8% in recent months, after declining nicely from 5.5% since 2022. As a result, the market had come to expect only one or two quarter point rate cuts by year-end, compared to as many as four or five at the beginning of this year.

We also added that the Fed’s reaction function for deciding whether and to what degree to cut rates later this year will likely be predicated on the core PCE falling convincingly toward 2% and/or the unemployment rate jumping meaningfully higher than 4%.

Last Friday, the unemployment rate increased to 4%; a level not seen since Q1 2022. From an economic and market perspective, the level may not be as important as the rate of change. A year ago during Q2 2023, the unemployment rate hovered around 3.6%. The reason that’s important is because, based on the Sahm Rule, it’s likely that the US economy will be entering recession if the rate soon reaches 4.1-4.2%. (According to the St. Louis Federal Reserve, the Sahm Rule “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.”)

While there has recently been some contradictory labor market data indicating that employment is actually increasing, we believe that the rising unemployment rate is closer to the truth and that the labor market and economy are weakening at the margins. In our view, this would be much more consistent with a slew of macroeconomic indicators and signals showing deterioration; such as the inverted yield curve, relatively weak leading economic indicators, cautious lending surveys, weak regional Fed data, and qualitative feedback published in the Fed Beige Book from economic participants across the country.

U.S. Unemployment Rate (recessions highlighted in red). Source: Bloomberg.

The chart above illustrates the unemployment rate since 1988 and periods of recession (highlighted in red columns). Indeed, upturns in the rate like we’re seeing today, strongly suggest an economic contraction on the horizon.

Notwithstanding, why does the question of recession matter to investors? After all, some US stock market indices (and other foreign indices) have recently hit all-time highs, certain credit spreads are relatively tight, and credit market conditions are seemingly excellent.

It’s relevant because economic contraction tends to correlate with not only slower earnings growth but also significant downside risk in equity indices. For example, within the context of the 2001 recession, quarterly earnings in the S&P 500 fell from $14.68 in Q3 2000 to $10.43 in Q1 2002. (Source: Bloomberg) Within the context of the 2007-2009 recession, quarterly earnings fell from $24.55 in Q3 2007 to as low as $5.87 in Q1 2009. (Source: Bloomberg) Based on the historical evidence, economic contractions can meaningfully impact the S&P 500.

Naturally, if earnings decline, stock valuations and stock prices are threatened. Between Q3 2000 and Q1 2002, the S&P 500 lost nearly 28%. Between Q3 2007 and Q1 2009, it lost almost 56%.

S&P 500 Index (recessions highlighted in red). Source: Bloomberg.

A lot of attention is being paid on Fed policy, inflation and employment data. Of course, a 2024-2025 recession isn’t pre-determined. But the history of the last few decades suggests that a slowly deteriorating labor market, which is what we might be seeing now, raises the specter of recession and weaker equity markets.