Global Co-Leader of Corporate Finance & Restructuring
FTI Consulting
Financial markets surged to post-COVID-19 highs on the heels of a shockingly strong May employment report from the Bureau of Labor Statistics, which was misleading at best in its estimation of the U.S. unemployment rate. Consensus expectations of an unemployment rate approaching 20% were blown away by a report that instead said unemployment moved to 13.3% from April’s mark of 14.7%. That data point gave ammunition to those predicting a V-shaped recovery. Myriad articles asked the same question: How could so many economists be so wrong?
However, a glaring disclosure on page six of May jobs report — it wasn’t even buried in the back pages — clearly explains that the unexpected drop in the unemployment rate was the result of erroneous classifications of unemployed workers who are expecting to be called back as employed workers. It is there in black and white for all to see, but apparently nobody noticed or cared to call attention to it.
There are two separate surveys reported in every monthly jobs report from the Labor Department: an establishment survey of businesses from which the new jobs data is derived and a household survey from which the unemployment rate is estimated. There was a whopper of a revelation in Friday’s report. Under the heading Coronavirus (COVID-19) Impact on May 2020 Establishment and Household Survey Data on page six of the report is a huge reveal that has been entirely ignored by commentators and markets. We show it verbatim below, with our emphasis added.
In the household survey, individuals are classified as employed, unemployed, or not in the labor force based on their answers to a series of questions about their activities during the survey reference week (May 10th through May 16th). Workers who indicate they were not working during the entire survey reference week and expect to be recalled to their jobs should be classified as unemployed on temporary layoff. In May, a large number of persons were classified as unemployed on temporary layoff.
However, there was also a large number of workers who were classified as employed but absent from work. As was the case in March and April, household survey interviewers were instructed to classify employed persons absent from work due to coronavirus-related business closures as unemployed on temporary layoff. However, it is apparent that not all such workers were so classified. BLS and the Census Bureau are investigating why this misclassification error continues to occur and are taking additional steps to address the issue.
If the workers who were recorded as employed but absent from work due to “other reasons” (over and above the number absent for other reasons in a typical May) had been classified as unemployed on temporary layoff, the overall unemployment rate would have been about 3 percentage points higher than reported (on a not seasonally adjusted basis). However, according to usual practice, the data from the household survey are accepted as recorded. To maintain data integrity, no ad hoc actions are taken to reclassify survey responses.
Let’s paraphrase this passage from the Labor Department: We know there are material misclassifications of workers who should have been classified as unemployed who were instead classified as employed in this report. We can even quantify the size of this misclassification and its impact on the unemployment rate, but we’re not going to correct it now because we have a policy of accepting survey findings as reported even if they are wrong. Should a correction be made in subsequent months, nobody will care.
Taking this explanation at face value, the unemployment rate would have been 16.3% in May instead of the reported rate of 13.3%. This implies that the number of unemployed Americans would have increased by 2.3 million in May instead of the reported decrease of 2.1 million.
Perhaps more surprising than this revelation is markets and commentators completely ignored it. Trading algorithms don’t read the fine print of government reports, nor do quant traders, day traders or market cheerleaders. A headline number and the momentum it creates is all that matters these days.
To be clear, there was good news in the May jobs report. Even if these misclassifications were corrected, the report would have been better than economists had anticipated, as most of them expected the unemployment rate to approach 20% in the month. Moreover, the number of jobs created, which comes from the establishment survey, was also stronger than expected, although BLS cautioned that survey methods and response rates continue to be affected by COVID-19. There are some solid reasons to conclude that the May report was better than dismal consensus expectations, but there also was an elephant in the room that nobody wanted to acknowledge. To do so would have disrupted a euphoric narrative that markets have completely bought into.
The shutdown of the economy in March through May in most sections of the country was not an organic event; it was implemented by states’ decrees in order to curtail the spread of the virus. Now that the national economy is being reopened, why is it so surprising that economic growth will rebound? When you fall into a ditch, the only direction is up, and the pertinent issue to ponder is not the size of that first step up but the time it will take to get out of the ditch. From that perspective, it will take quite a while to claw our way out of this one. Consensus estimates from more than 50 economists tracked by Bloomberg indicate that real quarterly GDP going forward won’t exceed a 2019 quarter until Q1/22, while the unemployment rate still will be double the pre-COVID-19 rate at the end of 2021.
Economic growth should resume starting in Q3/20. Nobody disputes this. Businesses will be reopening quickly this summer, and pent-up consumer demand resulting from many weeks of being housebound will need to be met. Most furloughed workers will be called back for months to come, but far too many won’t be — around six million or so will be axed for good. The anxiety around this permanent job culling will impact consumer confidence and spending for several years. Many economic statistics in the second half of this year will seem formidable without any context around them. But context is critical here; we will be sprinting to get back to a distant starting line.
S&P and Moody’s are both forecasting a low-double-digit speculative-grade corporate default rate by early 2021 compared with 4.5% currently, which would rival the heights we saw during the Great Recession. Can a resurgent economy and rebounding financial markets coexist with high unemployment and a sharp upswing in business defaults and bankruptcies? Only if enough people keep believing the economic happy talk. Reality prevails in the long run, but delusion can move the ball for longer than you think. The unemployment rate wasn’t 13.3% in May. Most people know it in their bones.
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
