Recent developments in the U.S. labor market have triggered the Sahm Rule, an economic indicator known for predicting the onset of recessions. Developed by economist Claudia Sahm, this rule signals a recession when the three-month average of the national unemployment rate rises by at least 0.5 percentage points above its low from the previous 12 months. Since the unemployment rate reached 4.3% in July, the three-month moving average of the unemployment rate is at least 0.5 percent above the three-month averages from the previous 12 months. The recent calculation yields a 0.53 percentage point increase from the lowest point in the past year, officially triggering the Sahm Rule and raising concerns about an impending recession.
While this indicator has a strong track record of signaling recessions before they are officially recognized, it is important not to jump to conclusions. Economic indicators can provide valuable insights, but they are not infallible.
Another widely watched indicator of a potential recession is the inverted yield curve, which occurs when short-term interest rates are higher than long-term rates. This phenomenon has been a reliable predictor of past recessions. However, it is worth noting that the yield curve has been inverted for an extended period without a recession materializing. This prolonged inversion raises questions about its current predictive power, particularly in an environment of unprecedented monetary policy and economic disruptions, and potentially the predictive power of the Sahm Rule as well.
It is also crucial to distinguish between economic performance and stock market valuations. Currently, the U.S. stock market is trading near all-time highs, with the S&P 500’s price-to-earnings (P/E) ratio around 25x, which is well above historical averages. This divergence between the stock market and the broader economy is not unusual. Historically, stock market performance and economic activity have often moved in different directions, particularly in the short term.
Source: Bloomberg, 2024
Perhaps these three indicators together suggest caution is warranted, and we would not disagree. However, we do believe that over the long run, any correction in markets would likely be in the form of sector rotation rather than a sustained liquidity driven liquidation of everything. Thus, the importance of staying diversified and focused on the long run. Our portfolios tend to be less correlated with the rest of the investment community, thus we believe they are a powerful diversifier.
In conclusion, while the Sahm Rule’s recent trigger suggests caution, it is not a definitive prediction of an immediate recession. Investors should be mindful of the risks but avoid overreacting. Ensuring a well-diversified portfolio that can withstand sector rotations and potential inflationary pressures is essential. As always, reviewing your investment strategy with a professional can help ensure you are prepared for whatever the market may bring.
If you are concerned about your portfolio’s exposure to current market risks, consider reaching out to Euro Pacific Asset Management for guidance on diversification and strategic investment planning.
