Recession Watch: Leading economic indicators
Summary: Evidence is mounting that the world is fast approaching the end of this economic cycle and perhaps, an outright recession. Opinions are many, but what are the facts? In this first article of a new series by our #SaxoStrats team,we take a closer look at the most powerful leading indicators that economists use to predict a recession.
The inverted yield curve is certainly the most critical signal to predict recession. Looking at the two-year/5-year spread, the track record in predicting recessions is about 80%. However, most research papers by the Federal Reserve point to the one-year/10-year spread as the most relevant spread to watch. That being said, an inverted yield curve does not mean that a recession is imminent. Based on the previous decades, it takes an average of 22 months for the recession to happen after the inversion of the yield curve.
The notion of Credit Impulse was introduced for the first time by Michael Biggs, in “The Impact of Credit on Growth,” Global Macro Issues, November 19, 2008. Instead of focusing on the stock of credit, Biggs indicates it is more important to focus on the flow of credit to understand the business cycle. He argues that since spending is a flow, that is financed through new loans, it should be compared with net new lending – also a flow – rather than credit outstanding – a stock.
Basically, credit impulse represents the flow of new credit from the private sector as percentage of GDP. It tends to lead the economy by 9 to 12 months and it has a high correlation with US final domestic demand and US private fixed investment. Decelerating credit impulse will lead to slower economic activity and negative credit impulse will produce sharpest slowdowns. Negative credit impulse has a decent track record in prediction recession since it has predicted all the recessions since 1950.
Commercial & Industrial loans and leases are an important category of assets that commercial banks report on their balance sheets. Its measurement is published by the Federal Reserve on a quarterly basis since 1947. It is usually considered as another reliable indicator of an upcoming US recession. Over the past decades, the contraction in C&I loans and leases has predicted the last three recessions.
The Conference Board Leading Index has been published since 1959. It is a leading indicator of the economic cycle that gives a broad overview of the state of the US economy. It is designed to point out peaks and troughs in the business cycle. It is composed of the ten data below:
– Average weekly hours, manufacturing
– Average weekly initial claims for unemployment insurance
– Manufacturers’ new orders, consumer goods and materials
– ISM Index of New Orders
– Manufacturers' new orders, non-defense capital goods excluding aircraft orders
– Building permits, new private housing units
– Stock prices, 500 common stocks
– Leading Credit Index
– Interest rate spread, 10-year Treasury bonds less federal funds
– Average consumer expectations for business condition
An annual contraction in the Conference Board Leading Index usually tends to signal recession. It has predicted the 8 past recessions in the USA, but it can also send incorrect signals, like in 1967 and in 1999. The amplitude of the contraction is the key criteria to monitor to assess the likelihood of a recession.
The Conference Board consumer confidence index is published on the last Tuesday of every month. It reflects prevailing business conditions and likely developments for the months ahead. Based on a track record that covers the past 50 years, the index reached its highest level at 144.7 in January 2000 and its lowest level at 25.3 in February 2009.
Even though we agree that history does not always repeat itself, it is interesting to note that, historically, extremely high levels of consumer confidence have been followed by recession and a lost decade, like at the beginning of the 1970s and at the end of the 2000s. Therefore, investors tend to be cautious when high levels are reached since it can be an early signal that an economic downturn is about to start.
Paperboard mills are what we call an unconventional indicator. Product sales by paper and paperboard mills tend to reflect the evolution of sales and, therefore, give a signal about the future evolution of production. This indicator was highly watched before the 2000s but, due to the digitalisation of the economy, it is certainly less reliable than in the past, though there is still an obvious correlation with the economic cycle.