INVESTMENT INSIGHTS

Is a recession possible with unemployment this low? We got some fresh unemployment figures last week, for both New Zealand and the US.

In both cases, the upshot was that the labour market is still extremely tight and wages are still rising solidly, albeit at a slower pace.

Against that backdrop, it’s hard to believe a recession might be on the doorstep of either country. Things can’t be that bad when everyone has a job and the labour market is still ticking over nicely, can they?

Our official unemployment rate is 3.4%, well above the multidecade low of 3.2% from a year ago. The US unemployment rate is also sitting at 3.4%, the lowest since 1969. The details looked equally solid.

New Zealand’s participation rate has risen to 72%, which puts it at the highest since data collection began in 1985. This measures the proportion of the potential work force who are employed, or looking for work.

This strength is likely a reflection of cost-of-living pressures forcing people back out to work, as well as better opportunities with many employers desperate to attract good staff. The validity of such low headline unemployment measures is often questioned, but things still look good if we consider broader measures of the labour market.

In New Zealand, the underutilisation rate includes like part-time workers who are keen to increase their hours, or those who are currently unavailable but will soon be able to start work. It's currently the lowest ever in data going back to 2009.

In the US, underemployment (a similarly board measure of labour market slack) fell to 6.6% last month. That’s the second lowest since this series started in 1994.

Wage growth in New Zealand remains strong, with average hourly earnings increasing 8.2% from a year earlier. That's down from where it was running last year, but it’s still extremely high.

From the perspective of economic activity and corporate earnings, this is great news. Low unemployment and strong wage growth usually point to a resilient backdrop and robust activity levels. When people feel confident about their job security, they’re likely to continue spending and behaving as normal, while the solid wage gains have helped offset increases in mortgage rates and the cost of living. At the same, this is keeping central banks nervous about inflation, which means they’ll be reluctant to take their foot of the brake pedal anytime soon.

The Reserve Bank of New Zealand has a recession pencilled in for later this year, while Federal Reserve staff are also predicting a US recession in the months ahead. These downturns are expected to be relatively mild, and nowhere near as painful as those seen during the pandemic of 2020 or the Global Financial Crisis 15 years ago.

For those wondering how a downturn could be possible at all when the labour market is so strong, don’t get your hopes up just yet. If you’re looking for clues to help signal the timing of the next recession or recovery, the unemployment rate isn’t one of them.

The labour market tends to be a lagging indicator. It is often strong heading into a recession, with unemployment only rising once the downturn has become entrenched, and continuing to increase after it ends.

In December 2007, just as New Zealand fell into recession, the unemployment rate was extremely low at 3.4%. It started rising once we were already in recession and it didn’t peak until the end of 2009, six months after the recession ended. It’s been a similar story in the US. There have been 11 recessions since 1950 and the unemployment rate has averaged 4.7% just before each of those started. That’s only just above the average low of 4.4% in each of those cycles.

During those periods the US unemployment rate ultimately reached an average of 8.5%, but that peak typically didn’t come until several months after the recession ended. There are a few reasons why unemployment is often out of sync with economic growth.

In the early days of a slowdown, businesses are reluctant to lay off staff as they want to retain that productive capacity in case the weakness proves short-lived. That's especially true following a period of labour shortages when it's been difficult to find staff, as is the case today.

There’s a similar lag coming out of a downturn. When the recovery first takes hold, businesses first try to get more out of their existing workforce. They're cautious about taking on more permanent staff until they see more evidence things are getting better. In short, we shouldn’t interpret the strong labour market as a reason to be complacent about the outlook.

Other reliable indicators point to cloudy skies ahead, and most economists (as well as central banks) are forecasting a recession, both here and in the US. Having said that, there’s still a chance we dodge a bullet, or at least avoid a severe downturn. The last three years have been so unique that forecasting has become very difficult, and the usual rules of thumb might not work quite as well.

The recent strength in migration is one example of a positive surprise few people saw coming. If this continues, parts of the economy could prove more resilient than expected. On the other hand, the business sector is likely to become increasingly cautious as the election draws closer, given the uncertainty that creates.

Low unemployment and a healthy labour market should be celebrated, but as encouraging as this might be, it doesn’t necessarily mean we’re out of the woods.

Craigs Investment Partners