Now, to explain the drop in the unemployment rate, let me first provide some definitions taken directly from the Bureau of Labor Statistics web site.
It is a counterintuitive notion, but the unemployment rate can actually improve (i.e., decrease) even as the labor market is deteriorating. Why? Because as active job seekers give up searching and leave the labor force (as defined above), this results in a decrease in both the numerator and the denominator of the unemployment rate. By way of example, let's assume we live in a country with an unemployment rate of 5.0% consisting of 95 million people who are "employed" and 5 million people who are "unemployed". Now, assume that job prospects deteriorate, causing 500,000 of those "unemployed" people to get frustrated and give up their job search, thereby leaving the labor force. The numerator of the unemployment rate, which is the "unemployed", would fall to by 500,000 to 4.5 million. The denominator, which is the "labor force", also falls by 500,000 to 99.5 million. The new unemployment rate becomes 4.5%, or 4.5 million divided by 99.5 million. Under this scenario, the labor market clearly deteriorated, which is why unemployed workers became frustrated and ceased their job searches. Nevertheless, the unemployment rate fell by 0.5%.
Now that we know that the drop in the unemployment rate from 5.0% in April to 4.7% in May was the result of people leaving the labor force, we can now see how the drop was consistent with the discouraging +38K addition to non-farm payrolls. In addition, it becomes much easier to explain the market reaction to the data. Since the end of the day last Thursday (the last day prior to Friday's employment report), the S&P 500 is up (albeit modestly), the yield on the 10-year Treasury bond is down from 1.80% to 1.70%, and the dollar index has fallen by 2.1%. The value of the dollar, which has fluctuated in recent years based largely on the prospect of Fed interest-rate hikes, has an inverse relationship with most commodity prices. Therefore, most asset prices, including stocks, bonds and commodities, have had a positive reaction to last Friday's woeful employment data. That's right folks. Bad news is still good news and good news still ain't so great. The simple reality is that investors continue to covet low interest rates over all else, including an improving economy.
What are the investment implications of the sudden downturn in the labor-market data? Unfortunately, not a whole lot. Employment data is widely viewed as a "lagging indicator", which means that the weakness in the data over the past couple of months simply confirms the economic growth deceleration we saw in the first quarter. However, the continued slide in the labor participation rate is clearly not a harbinger of an imminent breakout from the 2.0-2.5% economic growth since the Great Recession. Whether prospective workers are leaving the labor force due to demographic trends (retiring baby boomers) or out of frustration, fewer people working or looking for work is never a good thing for an economy so dependent on consumer spending. For now, probably best to tread carefully in industry sectors relying on this source of revenue.