Tea Leaves Suggest No Recession Ahead
According to government reports, the economy didn’t grow in the first quarter. Some worry that our economy might tip into another recession. Others, perhaps even more skeptical, think many signs of the economic recovery we have observed since The Great Financial Panic are distorted or artificial and driven more by financial factors rather than real, non-financial, fundamental factors.
Current data does not suggest a recession is imminent. First, non-financial, fundamental factors are moving in a direction suggesting the first quarter is more “noise” than “signal” of what lies ahead. Second, financial factors, specifically credit conditions, do not seem to signal recession either.
Securities markets are thought to be forward looking; to assess the current value of stocks and bonds, it is important to know where estimates of economic activity suggest we are heading. For this reason many pay attention to the Conference Board’s Index of Leading Economic Indicators (LEI).
The LEI is comprised of 10 components of both non-financial and financial economic activity designed to indicate peaks and troughs in the business cycle.1 The components, each called a Leading Index, are weighted by factors, rolled into a single data series, and released monthly by the Conference Board. The LEI is not a crystal ball; rather its main value is thought to be in signaling the risk of recession or recovery from one.2
A 30-year chart of the LEI is shown below. As yet, we have not observed a change in either the slope or direction (circled) of the LEI that typically presage recessions (blue shaded area).
Today, roughly three-quarters of the LEI is comprised of non-financial measures of economic activity, and the three largest factors account for over half of it. Presented below are current charts of these three leading factors.
Average Weekly Hours, Manufacturing (factor weight = .2713)
Average Weekly Hours, Manufacturing is the largest component of the LEI. We used average yearly observations above because month-to-month volatility can lend itself to “noise”. A number of factors affect this metric; perhaps the most significant among them is productivity gains. If we were entering a recession, we would expect to see a meaningful drop as employers begin to adjust employee hours in anticipation of a slowdown.
ISM New Orders Index (factor weight = .1606)
The ISM New Orders Index is one of our favorite economic indicators in part because it captures a simple idea: in a just-in-time economy new orders signal demand, and demand signals confidence and growth (as shown above by average yearly observations). Following the Great Financial Panic, new orders declined as fears of a European collapse weighed on purchasing managers’ confidence. Since the back-half of 2012, however, this trend has reversed. Note the downward trend of weakness prior to previous recessions (arrows).
Average Consumer Expectations On Business and Economic Conditions (factor weight = .1468)
Average Consumer Expectations on Business and Economic Conditions offers one of the clearest pictures as to why a recession does not appear in the offing. A downward trend of weakness is directly observable in periods prior to recession historically (first three arrows). Since The Great Financial Panic, and despite setbacks associated with the Fiscal Cliff and the European Union, the recent trend in this metric does not suggest recession (last arrow).
Perhaps it’s fitting to conclude with a picture of expectations, because from what we hear and read, we do believe that this transition from recovery to expansion has much to do with confidence. As employers and consumers gain confidence that the transition is real, we believe it could lead to longer and stronger growth. We think the probability of recession remains low.
We remain focused on understanding the current trends in fundamentals because it gives us the best probability for investment success.