Many economists and portfolio managers like to cite consumer spending, current GDP readings, and the unemployment rate as a sign that things are going well here in the U.S. However, these three indicators are either coincident or lagging indicators. They tell us nothing about what is likely to happen with our economy in the near future. This is why we must consider leading indicators, indicators that can help us glean information what what will soon happen to the overall economy. Continue reading to learn more about San Diego financial services and our recession indicators.
A recession, as defined by the National Bureau of Economic Research (NBER), is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” These observations were first recorded by Wesley Mitchell in 1927. By looking at historical records, we can conclude that there are 4 factors that tend to decline together, marking a recession:
On some occasions, there may be a temporary dip in one or more of these factors. However, the co-movement of all four is needed for an official recession to occur. All four of these factors tend to feed into each other. During a recession, people will lose their jobs (decline in employment). This will lead to a decline in income. As income declines, so will sales figures. As consumers buy less, output will decline and so on and so forth. During an upturn in the economy, this cycle also feeds into each-other, driving the economy higher.
There are leading indicators that can predict the turns in economic cycles. One of the more popular indicators is the inversion of the yield curve, when short-term interest rates rise above long-term rates. This is surprisingly a fairly accurate indicator. However, there have been times when it has failed to predict a recession, most famously the 1990-91 recession. As such, it is important to know that there is no single indicator that can accurately predict a recession without fail. The solution to this problem, is to take the composite index approach and to find leading indicators for the 4 coincident indicators mentioned above. In 1950, Geoffrey Moore did so by developing the composite index of leading economic indicators of recession and recoveries.
Sensitive Commodity Prices
Key commodity prices, often times used as an underlying driver of inflation, is a very important leading indicator for future economic growth. These commodity prices, such as oil, copper, and other industrial metals, can help us to determine if there is an economic expansion or decline taking place.
Average Manufacturing Workweek
Manufacturing workers are usually hired to work longer hours when their employers plan to hire more workers in the future. If there is a decline in demand for industrial goods, then employers will typically reduce the number of labor hours. Workers usually work fewer hours when employers plan to lay off workers in the future.
Commercial and Industrial Building Contracts
Tracking future construction activity via building contracts typically offers us a 9-12 month lead time. If the number of contracts dip and show a declining trend, then this is a sign of slowing economic activity.
Inverted Yield Curve
An inverted yield curve is a highly reliable tool to track if there is an expected slowdown in economic activity. A yield curve is a curve that shows interest rate points across several maturity dates. Most commonly plotted chart is the US Treasury bond yield curve due to its importance in the economy (after-all, it is the largest and most widely-held security in the world).
A normal yield curve will show a normal risk appetite among investors (lower rates among shorter maturities and higher rates among longer maturities):
However, the yield curve can flatten and eventually invert.
An inverted curve means that investors are expecting longer term rates to drop, thus the demand for longer term bonds is higher, sending yields down. While the yield curve is not a perfect indicator, it is a very good one. The problem with this indicator is that it sometimes will invert years before an economic slowdown. However, when used in conjunction with the other indicators, it is extremely useful.
Entrepreneurship plays a vital role in the growth of the U.S. economy as small businesses provide a large number of jobs and help push the economy forward.
More new orders for capital goods mean that firms will be producing more capital goods in the future. Fewer new orders mean fewer capital goods will be produced in the future.
When more building permits are issued, construction of houses will go up in the future. Fewer building permits mean fewer houses will be constructed in the future.
The M2 money supply includes currency, checking account deposits, and small savings deposits. If the money supply goes up faster than inflation, banks lend more and the economy can expand in the future. If not, the economy may contract.
While there is no single economic indicator that is 100% accurate, a composite approach of these indicators can help get an accurate look of where the economy is headed. We use these indicators to know when to under/overweight equities and to help protect our clients wealth. If you feel like you could benefit from a portfolio review or if you would like to learn more, please feel free to contact us.