Be wary of the recession predictor that has a perfect track record

Be wary of the recession predictor that has a perfect track record
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The unemployment rate tends to be a leading indicator ahead of economic downturns, but the series is also a lagging indicator ahead of economic recoveries.

This means that the unemployment rate goes up before the onset of recession but does not start coming back down until after the recession is over. This is unusual as most economic series fit into just one of three categories: leading, coincident or lagging.  

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Another advantage of the unemployment data is that the annual figures are not revised. This is not case with other popular series, such as GDP, nonfarm payrolls and retail sales. These data are susceptible to significant revision, which often means that what economists see in real-time is ultimately not the case.

At present, the unemployment rate is up several tenths of a percent from a record five-decade low. This may not seem like much, but the situation bears close watching, as we approach the threshold that has been associated with recessions in the past.

While the risks of an economic downturn have increased, this event is less than likely in our 2019 baseline projection. The expansion is likely to persist through year-end.

Unemployment data extend back to 1948. There have been 11 business cycles since, and the unemployment rate has always increased before the onset of recession. According to our analysis, the economy has always entered or has been in recession when the unemployment rate increased 50 basis points from its trailing cyclical low. This has occurred regardless of the level of unemployment.

For example, we had a recession in 1953 when the unemployment rate rose to just 3.1 percent, and in 1981 when the cyclical low in the unemployment rate was high at 7.2 percent. Hence, it does not matter if the unemployment rate, relatively speaking, is starting from a very low or very high level when breaching the 50-basis-point threshold.

Presently, the unemployment rate is 4.0 percent, which is already up 30 basis points from last November’s cyclical low. The current rise is notable and would be troubling if it continues. So, will it continue?

Our best guess is that the unemployment rate will drift back down below 4 percent in the coming months given that the recent increase has been due to rising labor force participation, off record low readings during this business cycle.

Therefore, the rise in participation, which is helping to lift the unemployment rate, is a positive development. It is a sign of economic strength not weakness — discouraged workers are re-entering the labor market, leading to an increase in measured unemployment.  

This suggests the labor market is not as tight as what meets the eye. Therefore, it is prudent that the Federal Reserve has taken a more patient course with respect to the timing of further interest rates hikes.

The loosening in financial conditions, which followed Fed Chairman Jerome Powell’s pivot away from a predetermined path of tighter monetary policy, bodes well for economic growth next quarter and beyond.

This will be welcome news for investors who are likely to learn the economy may not be expanding much at all this quarter.

Furthermore, the Fed is central to the forecast as financial conditions have meaningfully loosened in the last six weeks. The upshot is that the risk of a downturn is well under 50 percent. Yet, we will be paying close attention to the various other signposts of a peak in economic activity.

Indicators to watch include Institute of Supply Management's new orders, jobless claims, the yield curve, credit spreads and consumer expectations. Stay tuned.

Joseph LaVorgna is the chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the 2nd-largest banking group in France.