Coming off a topsy-turvy 2022, things are in a weird place economically. Mortgage rates are approaching 8%, the federal funds rate is up to 4.5% and likely rising and unemployment is… still quite strong. While low unemployment is typically an aspiration for modern economies, currently, most economists agree that higher unemployment is just what the country needs. Last month, stocks even fell on a stronger-than-expected jobs report. Is rising unemployment good or bad for the stock market?
Well, ordinarily, it’s objectively a bad signal. Unemployment is usually a symptom of imbalances in the economy. This could come in the form of lower corporate earnings, shrinking consumer spending, rising costs and other contractionary forces that push companies toward layoffs and stock traders toward selling.
Now, there may be good reasons for elevated unemployment, like the “Great Resignation” in years prior where large swathes of Americans left their jobs to find something better. But that kind of frictional unemployment is far and few between in the grand scheme of things.
With that said, currently, things are far from ordinary. For the past year, the Federal Reserve has had basically one objective: lower inflation by any means necessary. In pursuit of this goal, the central bank has spent the past year aggressively raising interest rates and letting its massive inventory of bonds expire from its balance sheet.
Despite its efforts, a year out from the start of the Fed’s “soft landing,” prices remain elevated. As per the latest Consumer Price Index report, prices are up 7.1% from the same time last year. That’s a far cry from the Fed’s 2% inflation target.
What does this mean for unemployment?
Rising Unemployment Is the ‘Hard Pill’ the Country Needs to Swallow
Unemployment has long been considered one of single most important economic indicators observed both domestically and abroad. While low unemployment has historically been considered a healthy economic goal, lately, there has been a unique reversal of that sentiment. Most economists and analysts are hoping for rising unemployment.
The fact is, the more the Fed tightens, both the likelihood and severity of a potential recession increase dramatically. Right now, the majority of market analysts see the country entering a recession at some point in 2023. If inflation doesn’t start to reflect the Fed’s efforts, the central bank will likely continue to raise rates until it does. Rising interest rates just about always hurt both stocks and corporate earnings. In that regard, it makes sense why so many analysts are pulling for a jump in unemployment.
As more Americans are laid off, the resulting reduction in spending is what will drive prices lower. Once that happens, the Fed can officially conclude it’s tightening, or even lower rates somewhat, bringing the long-whispered “Fed pivot” to fruition. In a sense, economists are hoping an increase in unemployment will serve as a precursor to falling prices and, eventually, a more dovish Fed.
It’s not very intuitive and it may even seem backwards to view layoffs in a positive light, but rising unemployment would likely read as a bullish indicator to investors and economists alike because of the implied Fed response. In June, former Treasury Secretary Larry Summers even commented on the sacrifices to unemployment the country would need to make to lower prices:
“We need five years of unemployment above 5% to contain inflation — in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment.”
For context, 7.5% unemployment would imply job losses of about 6 million, according to Reuters.
Unemployment and the Stock Market
Interestingly enough, the relationship between unemployment and the stock market isn’t nearly as straightforward as you might imagine. While rising unemployment is typically a negative indicator for the greater economy — and thus, the stock market — under certain conditions, stocks tend to increase alongside unemployment.
In a 2001 National Bureau of Economic Research (NBER) study on the stock market’s reaction to unemployment news, one of the grand takeaways is that, during periods of economic expansion, stocks usually rise on news of increasing unemployment. Indeed, rising unemployment is considered “good news” during economic expansions and “bad news” during contractions. The explanation is notably analogous to current market conditions:
“A rise in unemployment typically signals a decline in interest rates, which is good news for stocks, as well as a decline in future corporate earnings and dividends, which is bad news for stocks. The nature of the bundle — and hence the relative importance of the two effects — changes over time depending on the state of the economy. For stocks as a group, and in particular for cyclical stocks, information about interest rates dominates during expansions and information about future corporate earnings dominates during contractions.”
As of the fourth quarter of 2022, the country is in a late-stage expansion cycle.
Heading into the crucial jobs report this Friday, unemployment is the metric to watch. While it’s always strange to root for layoffs, at the moment, an increase in unemployment may be just the sort of “bad medicine” the economy needs.
On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
