Each recession is unique, but certain common variables typically persist. The Sahm Rule was developed to be a key coincident variable that is common across most, if not all, recessionary periods. The rule is straightforward: if U.S. unemployment rises by 0.50 percentage points or more compared to its lowest level in the past 12 months, it confirms a recession in the U.S., with a lag of one to eight months (the average lag is three months).

Source: FactSet

While we cannot say with 100% certainty that a recession in the U.S. won't occur in the near future or that the Sahm signal will prove incorrect (considering that historically, the time lag can extend up to eight months), it is crucial to remember that the business cycle and the dynamics of several macroeconomic variables in the U.S. are currently distorted due to post-Covid effects. These include the normalization of number of job openings, the recovery of migration flows and the stabilization of labor force participation rates. Typically, indicators confirming labor market weakness include a negative three-month average U.S. nonfarm payrolls and a steady year-over-year increase in the three-week average of unemployment insurance initial claims (as shown in the chart below). However, these indicators do not currently align with typical recessionary patterns, which may suggest either an atypical situation or that the Sahm Rule could be misleading under current conditions.

Source: FactSet, Freedom Broker calculations

Source: FactSet, Freedom Broker calculations

What indicators does the market usually focus on when evaluating the current business cycle?

It is important to remember that the Sahm indicator, like any other, is not perfect and requires confirmation from other indicators. For a long time, one of the popular and relatively clear leading recession indicators was the Leading Economic Index. However, like its counterpart, the Texas Index of Leading Indicators (from the Federal Reserve Bank of Dallas), it failed in its predictive role as both signaled an imminent U.S. recession in 2022-23. The reason these leading indicators "stopped" working lies in the same distortions of the economy following the sharp post-Covid recovery.

Source: FactSet, Freedom Broker calculations

The fact the LEI missed predicting a recession this time does not mean the indicator and its logic are flawed. Therefore, in the future, its signals should still be used in conjunction with other measures of economic activity. However, regarding leading indicators, besides the specifics of the current period, investors also concluded that it is essential not to overestimate so-called "soft data" (i.e., data based on surveys), which have been distorted due to heightened inflation risks (something U.S. citizens and businesses had long forgotten about), strong convictions among market participants and businesses in the inevitability of a recession, and due to recessionary signals from other indicators.

Among other popular recession-predicting indicators are the probability of a U.S. recession based on the spread between three-month and 10-year Treasury yields and the similar well-known empirical relationship between yield curve inversion and future recessions. Inversion has shown a good track record in predicting U.S. recessions retrospectively, so investors should not overlook it. At the same time, inversion ignores the macro context, which can differ from one cycle to another. Additionally, the context of rate levels relative to the neutral rate is important: if expectations of monetary easing arise when fed rates are close to neutral levels, it may indicate expected economic weakness; but if inversion occurs when current fed rates are significantly above the neutral level, the inversion may be a direct result of expectations for future monetary policy normalization. Furthermore, it is essential to consider the realities of the market: if at the beginning of the century, a 10-year Treasury yield of 3.80% to 3.90% was the norm, then in the middle of the last decade, the "norm" became about 2% to 2.50%, making the fixation of long-term portfolio yields at 3.80% to 4.50% (significantly below short-term bond yields) an attractive investment, as the market does not believe in long-term yield anchoring at such high levels (which stimulates inversion). It is important not to confuse cause and effect—inversion itself does not cause a recession.

* The probability of a recession is based on the yield spread between 10-year and 3-month U.S. Treasuries

Source: newyorkfed.org

Source: FactSet, Freedom Broker calculations

We suggest not getting carried away by dogmas and looking at the entire data set to better understand the overall economic picture. For example, the dynamics of the composite index of four coincident indicators (based solely on hard data) do not confirm a recession signal.

Source: FactSet, Freedom Broker calculations

Why we do not expect a recession now, or how strong is the consumer?

We started by stating that a single indicator, despite positive statistics, may prove unreliable if not supplemented with other variables. Considering other components of the labor market and other indicators, we do not currently expect a recession in the U.S. As, for example, the "non-recessionary picture" is painted by the indicator of personal consumption expenditure growth (explanation of calculations below), which does not show the typical decline for a pre-recessionary/recessionary period.

* The dynamics of personal consumption expenditure are less volatile compared to other GDP components. At the same time, the difference between the growth rate of PCE to date and the growth rate a year earlier can also serve as an indicator of the consumer's condition.

Source: FactSet, Freedom Broker calculations

It is also important to note that during periods of business slowdown, the most affected segments are usually investment/capital goods and durable consumer goods. As a proxy for the demand for durable consumer goods, we examine the dynamics of car sales in unit terms—a typical recessionary/pre-recessionary scenario involves declining sales with unchanged or falling fed rates. This scenario is not currently observed. Moreover, the current level of incentives for new car sales is only 7% of the average car price, compared to an average level of 10.50% observed during 2016 to 2019, indicating that consumer demand remains strong.

Source: FactSet, Freedom Broker calculations

*The dynamics is estimated YoY based on 3-month averages.

Moreover, we diverge from the view held by certain market participants who interpret the relatively low consumer savings rate as indicative of household weakness (at the same time, the current, more aggressive consumption pattern compared to what was observed in 2012 to 2019 is a risk factor). The chart below suggests the decline in the personal saving rate is a long-term trend driven by a prolonged cycle of declining interest rates and a stabilization of current consumption models. Importantly, despite the significant increase in interest rates, the proportion of debt servicing costs remains at the lower end of its 40-year range, indicating that we are likely nearing the bottom of the current demand cycle for goods (a point further supported by recent reports from Walmart (WMT, Financial) and Target (TGT, Financial)). Additionally, we believe that the ratio of liquid assets—checkable deposits and currency—to annual personal spending ratio (shown in the chart below) serves as a useful proxy for consumer cushion, which, combined with a low debt service payments as a percent of disposable personal income, suggests that consumers may be able to withstand higher interest rates in the near term.

Source: FactSet, Freedom Broker calculations

Source: FactSet, Freedom Broker calculations

Conclusions

Consumer is experiencing some pressure, and certain labor market indicators suggest a faster cooling of the labor market. However, based on other indicators, we do not foresee an imminent recession in the U.S. On the contrary, the data presented above points to the resilience of consumer patterns, even in the most volatile and cyclical sectors. While we remain vigilant about risks and data-driven, we maintain a positive outlook on the market overall, supported by the fundamentally strong economic backdrop and a favorable view on U.S. equities. We continue to favor large-cap stocks due to slightly deteriorating earnings per share expectations for small-cap companies. Our positive outlook remains for the following sectors: Technology, communications (Meta Platforms Inc. (META, Financial), Alphabet Inc. (GOOGL, Financial), Netflix Inc. (NFLX, Financial)), nealth care (Novo Nordisk A/S (NVO, Financial), Pfizer Inc. (PFE, Financial), Eli Lilly and Company (LLY, Financial)) and financials (Goldman Sachs Group Inc. (GS, Financial), Mastercard Inc. (MA, Financial)), while emphasizing the importance of being stock picky.