Economic update—Peak Worries?
Adding the Fed biz-cycle indicator to our toolkit
Published May 7, 2018
Is this as good as it gets for investors? Are we near business cycle peaks in the economy and corporate earnings? Is it all downhill from here towards recession and a “bear market” in stocks?
Our assessment of the fundamentals underlying the economy and corporate earnings suggest the current peak worries are just that—worries. A recession still is not likely anytime soon and the uptrend in general corporate earnings appears to be solidly intact. If so, probabilities favor the bull market in stocks remaining in place as well.
Let’s take a quick look at the business cycle fundamentals. In the past we’ve used the Institute for Supply Management (ISM) Index as a business cycle gauge as some may recall. For the past several months we’ve been researching another option.
The indicator we’re introducing—the Chicago Fed National Activity Index—is prepared by the Federal Reserve Bank of Chicago. It encompasses ISM data and many other points of information as well. In total, it includes 85 data series covering measures of production, orders, inventories, income, employment, and various components of consumption.
We admit its name (Chicago Fed National Activity Index) is a mouthful and its abbreviation (“CFNAI-M3”) is even worse, so we’ll just call it the “Fed biz-cycle indicator”.
It has generally been a decent leading indicator in terms of recession and inflation problems. It is not a perfect model of the economy—no indicator is. But it’s timely (updated near month end), readily accessible, and a good addition to our business cycle assessment toolkit. It is our intention to provide commentary updates on an on-going basis.
We favor two versions of the Fed biz-cycle indicator. One provides an assessment of where the US economy is within a business cycle. Another version provides an assessment of inflationary pressures.
Both versions have “threshold” levels which are like warning lights on a car’s dashboard. As chart 1 and the associated notes from the Fed of Chicago reflect, recessions have been associated with a threshold reading of -.7 and below.
Chart 1: Where is the US economy in the business cycle? No recession yet on the horizon.
Notes: Shading indicates official periods of recession as identified by the National Bureau of Economic Research. Following a period of economic expansion, an increasing likelihood of a recession has historically been associated with a CFNAI-MA3 value below –0.70. Conversely, following a period of economic contraction, an increasing likelihood of an expansion has historically been associated with a CFNAI-MA3 value above –0.70 and a significant likelihood of an expansion has historically been associated with a CFNAI-MA3 value above +0.20.
As chart 2 and the accompanying notes suggest inflation becomes an issue in the threshold above a +.7 reading.
Chart 2: Is an inflation problem brewing? Not at this point.
Notes: Shading (in chart 2) represents periods of sustained increasing inflation. An increasing likelihood of a period of sustained increasing inflation has historically been associated with values of the CFNAI-MA3 above +0.70 more than two years into an economic expansion. Similarly, a substantial likelihood of a period of sustained increasing inflation has historically been associated with values of the CFNAI-MA3 above +1.00 more than two years into an economic expansion.
The bottom line?
- Business cycle indicators suggest the economic expansion likely has more room to run.
- Indicators also imply the economy is not terribly inflation-prone. Inflation may well tick up, but…
- The Fed doesn’t need to jump on the monetary policy “breaks” to address an inflationary excess any time soon.
- The corporate earnings uptrend remains in place.
- The bull market in stocks should continue.
We remain focused on understanding the current trends in fundamentals because it gives us the best probability for investment success.