Investment theme #1 - Leading indicators: no end in sight

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  • 14/12/2016

The value destruction that characterised 2007/08 has persuaded many that it is more important to focus on missing the bad times, rather than being invested through the good. The post-war period tells us this is patently not true.

Nonetheless, there are five indicators that we continue to watch very carefully for any signs that the cycle end is close. Below, we explore what the five indicators currently tell us and why we value their input. It is worth remembering that none of these is infallible – all require interpretation and context, much as the last few years has proved with reference to the many leading indicators warped by lower commodity prices, unconventional monetary policy and near-zero interest rates.

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Residents of the United States, please read this important information before proceeding

1. ISM surveys (Figure 3): the ISM manufacturing survey remains the longest-running and most trusted cyclical lead indicator. Earlier work on the ISM surveys with regards to forecasting GDP suggested over 60% of the moves in GDP can be explained by the ISM surveys1. The plunge in oil prices clearly impaired the reliability of the ISM Manufacturing earlier in the year, but both manufacturing and services surveys now sit at levels consistent with trend economic growth.

2. Yield curve (Figure 4): in the post-war period, an inverting yield curve (2-year yield moving higher than 10-year yield) has preceded every single recession. There has been one false positive in 1967, where a credit crunch but no recession materialised. However, in all other cases, the economy had slipped into recession in less than 12 months after the signal had been given. Many worry about the massive central bank bond purchase programmes and near-zero short-term rates distorting this signal, and have made some attempts to compensate2. The level of the yield curve is currently consistent with no imminent US recession.

3. European interbank rates and credit default swap (CDS) spreads (Figure 5): it remains hard to have a fully-fledged banking crisis without it showing up in either CDS or interbank lending rates. The latter should represent the liquidity situation within the banking sector, while the former tends to reflect balance sheet quality fairly accurately3.

4. Narrow money (M1) growth (Figure 6): the ECB’s very thorough study of the relationship between M1 growth and recessions, suggest that when M1 growth moderates to zero year-on-year or below, a recession has tended to come within 18 months4. One possible reason for this is that M1 holdings are related to actual spending, since they are mostly money balances held for transactional purposes. A deceleration in M1 likely signals a slowdown in spending and economic activity. Right now, M1 growth is not at levels that are consistent with any alarm.

5. Private sector balance (Figure 7): this is a representation of private sector free cash flows, aggregating cash flow from the corporate sector and incomes from households, and detracting inventories and residential investment respectively5. The last two recessions have seen the private sector balance retreat into deficit. On its own this doesn’t have to be a sinister phenomenon, though in concert with other indicators could be seen to be an approximation of the level of private sector exuberance. Current levels indicate further to run in this economic cycle.

1 In Focus, A tale of two indicators, 15 January 2016
2 The Yield Curve as a Leading Indicator – FRB New York, Wu-Xia Shadow Federal Funds Rate – FRB Atlanta
3 Are CDS spreads a good proxy of bank risk? – Chiaramonte, Casu, August 2010
4 Stylised facts of money and credit over the business cycle – ECB, October 2013
5 The Private Sector Deficit Meets the GSFCI: A Financial Balances Model of the US Economy – Hatzius, September 2003