Cracks in the Labor Market?

By Adam Thurgood on June 26, 2023

We live in an economy driven by the consumer.  As such, consumption plays a massive role in the path of economic activity.  Consumption is a function of money burning holes in peoples’ pockets and those holes tend to widen when unemployment is low.  With the unemployment rate sitting near all-time post-war lows (3.7%), it’s no surprise the economy has remained resilient.

Despite a strong labor market, many leading economic indicators are pointing towards recession (check out our May client briefing for more on this).  Is it possible to have a recession without people losing their jobs?  History would say no.  As you can see in the chart below, recessions (red bars) come with increases in the unemployment rate (orange line).  What surprises many clients we speak with is that the peak in unemployment usually comes after the recession is over, which helps explain why the unemployment rate is a lagging indicator. 

Given the lagging nature of the unemployment rate, we need to look under the hood of the labor market to get a sense of when the tide may be turning.  I tend to look at four components to assess the underlying health of the labor market; continuing claims, ease to fill job openings, overtime hours worked, and Kansas City Fed labor market conditions.  Let’s start with initial claims.

Initial claims data is released weekly, so it doesn’t suffer from as much lag as the other monthly data.  Due to the crazy jobless claims during the pandemic, the chart becomes unusable if we include the Covid period, so I stopped it in 2019 for illustrative purposes.  The chart below shows the initial claims data in orange on the top with the 12-month rate of change in blue on the bottom.  If history is any guide, once we get a sustained rise of more than 20% in initial claims, we are likely headed for or already in a recession.  The last two weeks we have seen 20%+ gains.  That’s not “sustained” enough for a clear signal, but it is certainly in the danger zone and shows weakening in the labor market.

The next indicator I like to look at is the NFIB Small Business index; specifically, the sub-index related to how hard it is to fill open jobs.  When the index is rising, it is hard for businesses to fill positions and vice versa.  Intuitively, if jobs become easier for business to fill that likely means more people are out of work.  When the 3-month moving average crosses below the 36-month moving average, it has been a clear signal that recession is near.  I picked this indicator up from Will Denyer of GaveKal and have watched it closely for years.  Today, the indicator is not quite predicting recession but it’s very close.

Manufacturing overtime hours worked is also an interesting gauge of the strength of the labor market.  When overtime hours are high, it’s an indication that the economy is humming.  Sustained declines in overtime hours worked (10%+) typically coincide with economic weakness.  We’ve been in just such a sustained decline since the beginning of the year.  This indicator suggests the labor market isn’t nearly as strong as the media would lead us to believe. 

The final indicator to assess is the Kansas City Fed labor market conditions index.  This index is a composite of 24 indicators and gives a broad measure of the health of the national labor market.  If you look at the index on a “levels” basis, it is extremely elevated, meaning the labor market is strong.  However, if you look at the trend it tells a different story.  When the 3-month moving average has fallen below the 24-month moving average, it has been a great predictor of recession on the horizon.  The trend broke negative in March and is flashing a red light that a recession is coming. 

When I take a step back from the day-to-day madness of markets ripping higher, I find it hard to avoid the conclusion that a recession is coming.  The slew of leading indicators pointing to recession, along with these four indicators showing cracks in the labor market, at the very least make the case to be careful with positioning of portfolios.  As I discussed in “Has the Market Bottomed”, if a recession is here or coming in the not-too-distant future, a major correction would be par for the course.  As a result, we continue to stay defensive in portfolios.