Christopher Bremer

Senior Investment Consultant

 

Overview

This spring, economists have become fond of using the term “green shoots” to describe the first signs of recovery. The phrase has spiraled out of control among the financial media and has come to represent opposite ends of the economic outlook, between those who view less negative economic data as pointing to economic recovery (the bull argument) and those who argue the fallacy of the term and the dangers of assuming the worst is over (the bear argument).

The phrase took hold when Federal Reserve Chairman Ben Bernanke, mentioned it on a March 15 airing of “60 Minutes.” Speaking specifically on people getting out of high mortgages, progress in the money market mutual funds, and in the business lending area, Bernanke stated, “I do see green shoots. And not everywhere, but certainly in some of the markets that we’ve been functioning in. And we’ve seen some improvement in the banks, as well.”

Considering a quick Google search of the phrase will turn up almost three million results, the phrase will no longer be used throughout the remainder of this commentary. Be cautious of media outlets using the aforementioned term, either in support of economic recovery or as a proxy that investors are far too complacent. For example, one Wall Street research firm recently defined the phrase’s underlying premise as, “a quick return to normalized credit markets and normalized earnings [that] rests on a shaky foundation and an overly optimistic view of global economics.” Any personal view of the economic environment notwithstanding, Bernanke’s simple statement on the improvement in some financial markets has been blown completely out of proportion. Instead of focusing on such misrepresentations, investors should consider taking a closer look at some economic indicators that may signal the economy may be healing.

There are typically three types of economic indicators: coincident, lagging, and leading. Coincident indicators tend to commonly identify the current economic environment and are likely to show how the economy is currently behaving. The National Bureau of Economic Research (NBER) uses them to identify expansions and contractions in the business cycle. Gross national product (GNP), non-farm payrolls, industrial production, retail sales, and personal income are some widely recognized examples of coincident indicators.

Lagging indicators typically have movements that follow those of coincident indicators and are intended to confirm that an economic trend is occurring or about to occur. As the name suggests, they tend to be the last indicators to turn when confirming a change in economic trends. In some cases, lagging indicators, such as cost factors, can impact the direction of leading indicators. Examples include mortgage rates, unit labor costs, and the unemployment rate.

Leading indicators tend to be more anticipatory in nature. They often provide a preview of future economic activity. Because leading indicators are designed to reflect the early stages of production and investment, they generally reflect early changes in economic conditions. Stock prices, money supply, interest rate spread, housing permits, and weekly initial unemployment claims are often cited as examples of leading indicators.

This month we take a closer look at a few leading and coincident indicators that may provide us with some comfort as to whether the domestic economy is on the road to recovery. (Fig. 1.)

Stock prices a leading indicator

Equity indicators can prove to be very useful in identifying turning points in business cycles for two reasons. First, the stock market serves as a great discounting mechanism. Here, finance theory collides with old-fashioned supply and demand pressures. Essentially, valuations reflect expectations about future earnings and profitability, as well as economic growth prospects. In this regard, market participants argue that stock prices are anticipatory, or forward-looking, and therefore offer some predictive ability to determine the direction of the economy.

If stock prices are a leading indicator, then if the economy is expected to expand investors will bid up share prices and businesses will be more likely to hire or pursue expansion projects. Likewise, if the outlook for profits is grim investors will bid down share prices and companies will not hire or replenish inventories.

The second argument in favor of the predictive ability of stock prices is identified as the “wealth effect.”¹ Here, economists suggest consumption is directly related to changes in wealth. Stock prices serve as the catalyst for economic expansion and contraction. In other words, if investors experience an increase in their assets or wealth because the stocks they own have appreciated, they will spend and consume more than if they did not experience an increase in wealth. As a result, the economy expands. Conversely, if investors experience deterioration in wealth resulting from a decline in the stocks they own, they will save more and spend less. As a result, the economy contracts.

When we look at the empirical record, one could make the argument that stock prices tend to lead the economy. With respect to expansionary periods, it appears that stock prices lead economic upturns by an average of four months.² If the S&P 500 Index bottomed on March 9, 2009, then the market is predicting that an economic expansion should be unfolding by mid-summer. (Fig. 2.)

Credit spreads also a leading indicator

The recent financial crisis is largely the result of investors being too complacent regarding risk coupled with the widespread use and abuse of leverage. In many respects the credit crisis dragged the economy deeper into recession than what would have typically occurred. Credit is the oil that makes the machinery of finance and commerce run. When the flow of credit is curtailed, shockwaves spread through the system. Eventually the gears of commerce slam into reverse and economic activity grinds to a halt. Most notably we saw banks unwilling to lend, including to other banks, and investors demanded much higher interest rates to hold corporate debt as bankruptcy fears permeated the marketplace. Positive developments in the credit markets are critical in signaling an end to the economic downturn and helping provide a glimmer of hope that an economic expansion may be on the horizon.

While we may not be out of the woods yet, it appears the government sponsored capital infusions and aggressive monetary policy directed by the Federal Reserve have begun to allow credit to flow. The London interbank offered rate (Libor), the rate at which banks charge each other to borrow in dollars, which peaked at 4.82% in October 2008 declined to 0.79% as of May 18, 2009. (Fig. 3.) The spread, or yield differential, between Libor and U.S. Treasury Bills measures both the cost and willingness of banks to lend to each other.

The spread above suggests less perceived credit risk in the banking system, historically low borrowing costs, and more liquidity in the banking system since the beginning of the year.

A more esoteric measure, the TED spread, can be used as an indicator of credit risk. This spread reflects the price difference between three month U.S. Treasury Bill futures contracts and three month Eurodollar futures contract. Eurodollar futures serve as a proxy for the perceived credit risk of corporate borrowers. As the TED spread increases, investors become more concerned about credit risks. As that spread decreases, credit risk is presumed to be decreasing. As of mid-May, this spread had narrowed to its lowest level since August 2007.

An additional indicator of credit conditions is the yield on long-term investment grade debt. Here, investors can view the Moody’s Investors Service Baa bond yield less long-term U.S.Treasury yield spread as a measure of how much risk is perceived in owning corporate bonds. (Fig. 4.) Likewise, this yield differential also serves as a barometer for the cost that corporations must pay, over and above a risk-free U.S. treasury rate, to borrow from investors. As the outlook for credit conditions and the economy improves, investors tend to shy from the safety of government bonds and become more comfortable taking on the incremental risk and higher yields associated with investing in corporate bonds. As a result, corporate bond prices get bid up which leads to a narrowing of credit spreads.

In November Baa spreads reached their highest level since the Great Depression. Since then, we have witnessed a significant narrowing in investment grade credit spreads. The Moody’s Baa less long-term Treasury yield spread has historically led economic expansions by a median of one and a half months.³

Non-farm payrolls a coincident indicator

Employment is a coincident to lagging indicator of expansions and probably the most important indicator used by the NBER in defining business cycles. The Conference Board’s Coincident Economic Index assigns over one-half of the index weight to non-farm payrolls. In fact, the monthly release of the Bureau of Labor Statistics non-farm payrolls report is arguably the most widely read and anticipated monthly economic report with audiences spanning from investors to economists to politicians. When the economy is growing, businesses increase payrolls (jobs) in order to meet demand. Strong business demand allows workers to demand more pay. Conversely, when business demand softens, demand for jobs decreases and eventually leads to layoffs.

Ned Davis Research found that the maximum monthly jobs loss has typically led an upturn in the economy by a median of two months. The April change in non-farm payrolls perhaps best reflects the debate over what may be growing this spring, plants or weeds. (Fig. 5.) The April change in non-farm payrolls came in at -539 thousand versus a consensus expectation of -600 thousand. The actual result is far better than what most economists expected, but the result itself is a brutal reminder that we are still in the midst of a severe recession.

New homes sales a leading indicator

Housing was a good leading indicator and, of course, contributed greatly to the current recession. The most recent data for the S&P/Case-Shiller Home Price Index shows a continued broad- based decline in the price of single family homes across the country with one-half of the major metro areas showing record declines. (Fig. 6.) Optimists note that for the first time in 16 months however, the 20 city composite did not set a new record in the annual rate of decline.

Many economists believe that an improvement in the economic cycle must be preceded by a bottoming of home sales and price declines. (Fig. 7.) A minimum of a few more months of data is needed before determining if home prices have finally bottomed. A trough in new home sales has historically occurred approximately two to three months before the beginning of a new expansion cycle, but this indicator has been extremely volatile. Single-family building permits are also widely followed, but appear to have even wider variability in signaling economic recoveries. Both gave strong positive signals during the 1980-81 and 1990-91 recessions when the U.S. economy went through sharp housing contractions. Another key factor is that improved home affordability is clearly helping. Low mortgage rates and price declines are showing signs of increasing demand for new homes.

Where are we Headed?

Prior to the financial crisis that unfolded last year the U.S. economy was already headed for a slowdown. The collapse of the financial system was avoided last fall as a result of herculean fiscal and monetary policy responses that were coordinated on a global basis. The current recession is now into its 18th month. This qualifies as the longest economic contraction in the post-World War II era.

Attempting to identify the inflection point when a recession has ended, as declared by the National Bureau of Economic Research is a challenge considering the NBER typically publishes such data well after the fact. But there are encouraging signals. For instance, the decline in housing prices appears to have moderated, commodity prices are stabilizing, and equity prices have rebounded handsomely from their lows in early March. So, is the dark and cavernous freeze of the recession starting to thaw? Is the domestic economy in the midst of a renewal? Or, will the early plant growth turn out to be dandelions?

The debate over what less-dismal-than-expected economic data means should not be taken to mean the economy has recovered. Let the media pundits proclaim their euphoria for early plant growth green in color. A conservative approach might be to place the debate into a greater context. Only months ago the debate raged over deflation and depression. Now the debate rages over a phrase far extended beyond its original context. One need not necessarily buy into the analogy of sprouting plants to consider that, at a minimum, some economic data contains a flicker of hope.

We have maintained that improvement in economic data accompanied by improvement in economic sentiment and expectations will help to heal and eventually revive our economic markets, albeit at a more moderate pace than experienced in the run up to the current recession. We need not determine which comes first, but rather like coincident indicators the important part is that they trend together over a sustained period of time.

As John Kenneth Gailbraith once said, “The only function of economic forecasting is to make astrology look respectable.” Looking through the crystal ball to foretell the economic future is not simple. While it may be difficult to foresee the return of economic normalcy given the backdrop of 2008 and 2009, we encourage investors to take the long view. The economy and markets are self-adjusting mechanisms. A more moderate economic environment will return, although perhaps not this year.

Investors and economists are scrutinizing all economic data for signs of stabilization or deceleration in the rate of decline. Indicator readings provide valuable signs that the current state of affairs surely lie somewhere between plants and weeds. Indicator readings do not follow linear paths, but we can use them as tools to help us form opinions regarding anticipated recessions and recoveries. As we reach toward the end of the second quarter, signs of reaching a point of inflection have begun to appear.

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¹ Pearce, Douglas K. “Stock Prices and the Economy.” Federal Reserve Bank of Kansas City Economic Review, November 1983: 7-22.

² Ned Davis Research, Inc.

³ Ned Davis Research, Inc.