string(7) "interna" Financial Education | 29 July, 2018

Is it good for the stock market to lower unemployment?

Diego Balsa Portfolio Manager

The immediate answer could be that a low unemployment rate is good for the stock market.

In the last few years, the unemployment rate has registered a marked decrease in the main geographical areas and has reached historical lows. One of the questions arising from these circumstances refers to the impact of these employment rates on equity performance.

Firstly, because if the labour market is performing well, people will consume more and, as such, business earnings will rise. Also, when unemployment rates are low, the general economic situation is good and conditions are more favourable for companies.

However, as this chart shows, the historical link between equity performance and the unemployment rate consists in greater return for the stock market when unemployment is high, and vice-versa.

In other words, contrary to what you may think, historically speaking, very low unemployment is not good for equity.

But, how can equity perform worse when unemployment is very low and how can the stock market be at its best when unemployment is extremely high?

This is explained by several factors, which we try to summarise below:

  • When unemployment is high, the authorities traditionally implement strong measures to stimulate the economy and taxation. Also, these measures mean a decrease in policy rates. All of them stimulate growth, increase liquidity and reduce financing costs and corporate taxes. On the other hand, when unemployment is low (such as in the USA at the moment), the authorities raise the official rates and implement much more restrictive policies. This has a huge impact on business accounts and, historically, slows down the economy’s growth rates and, ultimately, leads to a recession.

 

  • Equity performance is not solely based on what happens now; it is largely dependent on future estimations. As such, when the economic situation is very favourable and unemployment very low, investors are usually too optimistic in their estimations. However, the economy is always very cyclical and when the economic indicators start slowing down (even if they are still good), the market is disappointed because it expected them to be better. And this leads to downward pressure on share prices.

 

  • Corporate expenses are mostly tied to salaries and when unemployment is very low, wage pressures increase and reduce profits significantly. The opposite happens when unemployment is very high.