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James Athey's view on: Uptick in unemployment may be early warning of US recession

It was once said of investing that in the short run valuation does not matter, but in the long run it’s all that matters. There is genuine wisdom within that pithy phrase – and it could be said that the same reality is true of the economic cycle.


In the very short term as market prices ebb and flow, based on the whims and emotions of traders and investors and the emotionless actions of algorithms designed to scan news headlines for trading signals, it’s hard to see the economic cycle as the predominant driver of returns. Once you pull back and view matters from a greater height and over longer periods of time it’s hard to avoid the conclusion that it is the economic cycle which dominates the shifting pattern of returns across bond and equity markets.

This raises an obvious challenge for forward-thinking, long-term investors – working out where we are in the cycle and thus what comes next.

Our starting point is to consider the economic cycle at its most basic level. Ultimately economies expand and contract because of a series of self-reinforcing actions and interactions between the various actors which form an economy. The most consistent and significant of these is the labour market. During the good times, when consumers feel confident and spend more freely, workers are hired by companies needing to expand production to satisfy increasing demand for their goods and services. As people are hired and thus move from unemployed to employed this creates a jump in their income which leads to a jump in their consumption. This increased demand ultimately results in the need for more workers to satisfy the additional demand, which in turn further increases employment. Thus, the cycle feeds off itself in a positive fashion. This dynamic is especially pronounced in modern, Western economies where consumption is often up to 80% of the economy. Consumption is the engine of growth and increased employment is the engine of consumption. If that employment engine seizes for any reason, then it is significantly more difficult to generate sustained positive growth outcomes and if the seizure is severe enough, or long lasting enough, then it will lead to the flip side of that virtuous process – consumption falls because people lose their jobs, which makes consumption fall. A recession.

Therefore, it stands to reason that to assess where we currently stand in an economic cycle the labour market is a good place to start.

Source: Bloomberg

We can see from this chart that recessions have occurred during, or at the end of, periods of rising unemployment – exactly as described above. A keen observer might draw three further relevant conclusions – unemployment today is at a low level relative to history, it has recently begun to rise and when these two facts have been true historically, the result has been a recession.

These simple but valid observations, understandings and historical comparisons strongly suggest to us that the US economy is at the end of a cycle rather than in the middle or even at the beginning. As a result, even without specific foresight or without making bold predictions, we feel that there are clear investment implications.

Once again to assess those implications we turn to history. As Mark Twain is reputed to have said – history may not repeat but it often rhymes. The table below is purely illustrative and is not meant to accurately describe investment returns for any particular investor or investment approach. Yet the message is important – exposure to the bond market is desirable during periods of rising unemployment and economic weakness – particularly as a counterweight to highly cyclical equity exposure.

Source: Bloomberg, returns in US Dollars

We don’t have the ability to predict with any degree of accuracy what happens next, when a recession will begin in the US or indeed if one will even occur. However, our job as investors is less about making confident predictions about an unknowable future and more about assessing the balance of probabilities and how these may differ from the implied probabilities contained within market pricing. In that respect the calculation for us is a bit more straightforward. We know that unemployment is low by any reasonable measure and low relative to history. That means economic gains from increased employment will be significantly harder to come by in the near future than they have been in the previous few years. We know that unemployment has recently begun to gently tick higher. We know from history that when those two outcomes coincide a recession has usually followed, and we know that historically during periods of rising unemployment and recession it is the bond market which has allowed investors to preserve capital. This simple framework and calculation significantly, but not exclusively, informs our view that it is an attractive time to invest in the bond market.


Pithy phrase - A pithy phrase or statement is brief but full of substance and meaning.

Economic cycle - An economic cycle is the overall state of the economy as it goes through four stages in a cyclical pattern: expansion, peak, contraction, and trough.

This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.