Where Does The Economy Go From Here?

THE BIG PICTURE

Last Update: 24-Sep-12 08:52 ET

Briefing.com

Leading Economic Index Reflects Risks

The Leading Economic Index provides a broad gauge of the likely trend of the US economy. The index currently signals a worsening economic outlook. The breakdown of the data clearly reflects the trends in key sectors.

The Index

The Leading Economic Index (LEI) is produced by the private Conference Board (it was originally produced by the government but was subsequently privatized).

It is a composite based on ten economic variables which have been proven to correlate extremely well with future economic trends. The composite components are:

1. Average weekly hours, manufacturing.
2. Average weekly initial claims for unemployment insurance.
3. Manufacturers' new orders, consumer goods and materials.
4. ISM new orders index.
5. Manufacturers' new orders, nondefense capital goods excluding aircraft.
6. Building permits, new private housing units.
7. Stock prices, 500 common stocks.
8. Leading Credit Index (from the Conference Board).
9. Interest rate spread, 10-year Treasury bonds less federal funds.
10. Average consumer expectations for business conditions.

History

Below is a chart of the year-over-year change in the index since 1995.

 

The index has trended steadily lower prior to the last two recessions.  It has presciently forecast all economic recoveries the past two decades. These are the key swings since 1995.

1. The index trend started to drop in January 2000, and turned negative by December 2000. The economy entered recession four months later in March 2001.
2. The index trend turned upward in July 2001 and the economy exited recession six months later in December of 2001.
3. The index peaked in March 2004 before commencing a steady downtrend. The index went negative in August 2006 but stagnated for a while before turning steadily south in April 2007. The economy entered recession eight months later in December 2007.
4. The index bottomed in December 2008 and trended higher until March 2010. That presaged the rebound from the recession starting seven months later in July 2009 that produced 4% real GDP growth through the end of 2010. 

The recent trend is troubling.

The index turned downward on a steady basis beginning in March 2010. It is now up only 2% on a year-over-year basis through August data. (The August index actually declined 0.1% but the year-over-year change managed to rise because there was a sharp downward spike last August when stock prices fell on the debt ceiling scare.)

The LEI does not yet suggest the US economy will enter recession, but the trend is worsening. The index suggests that the outlook for the US economy is for very sluggish growth the next several quarters, and that the economy is perilously close to entering recession.

An exogenous shock, such as a credit disruption in Europe or enactment of even a portion of the fiscal cliff, could easily trigger uncertainty that would drive the US into recession.

The Component Story

The contribution to the total index of each component for the past five months is listed below.

	August	July	June	May	April
Manuf. Workweek	-0.07	0.0	0.07	-0.07	0.07
New Claims	-0.05	0.18	-0.06	0.05	-0.19
Consumer Gds. Orders	-0.01	0.29	-0.13	0.02	0.05
ISM Orders	-0.17	-0.15	-0.16	0.10	0.06
Nondefense Cap. Gds. Orders, ex air	0.10	-0.15	-0.11	0.08	-0.06
Building Permits	-0.03	0.18	-0.08	0.22	-0.17
Stock Prices	0.12	0.10	-0.05	-0.13	-0.01
Credit Index	0.08	0.03	0.04	-0.02	0.05
Interest Spread	0.17	0.15	0.16	0.18	0.20
Cons. Expectations	-0.15	-0.11	-0.12	-0.06	-0.07
Total Index	-0.1%	0.5%	-0.5%	0.3%	-0.1%

The components fall into four broad categories.

The average weekly hours and new claims data reflect early trends in the labor market. Over the past five months, the manufacturing workweek has been flat, and new claims have trended slightly upward, subtracting a net 0.1% from the monthly changes. Labor market conditions are deteriorating.

The manufacturing new orders, ISM new orders, and nondefense capital goods orders reflect early trends in production. These three components have subtracted a net 0.2% from the index the past five months. The manufacturing sector is weakening.

Building permits, stock prices, the credit index, and the interest rate spread reflect monetary policy. To some extent they are all driven by the Fed's quantitative easing. The Fed is directly trying to keep the interest rate spread a positive influence by keeping short-term rates low, and is indirectly trying to boost stock prices and to promote credit extension. Housing permits reflect the Fed's action to buy mortgage-backed securities. These four components have added a net 1.2% to the index. The vast majority of this comes from the interest rate spread.  Monetary-related components are rising.

The fourth category is consumer expectations. It has fallen each of the past five months but the September data has already been reported higher. It has been a negative for the index, subtracting 0.5%. Consumer sentiment is weak.

These categories clearly indicate that without the extremely easy monetary conditions and Fed efforts to enhance liquidity, the index would probably have already gone negative on a year-over-year basis.

The component trends in the index suggest the Fed is keeping the economy out of recession.

The trends also reflect the extremely strong current that the Fed is swimming against. Despite firing almost every bullet in its arsenal, the Fed is having little impact outside of the directly monetary-related sectors.

Overall, the index is up a meager 0.1% in total over the past five months.

What It All Means

The Leading Economic Index suggests that the US economy will grow at a very sluggish rate the next few quarters.

The Fed's extreme monetary actions are all that is keeping the economy out of recession.

If the impact from these actions does not continue, a recession is possible.

A decline in stock prices or a loss of confidence in the housing market by homebuilders could turn the LEI negative for a period of months.

The stock market is underestimating the downside risks to the US economy that the LEI clearly reflects.

Dick Green

Founder and Chairman, Briefing.com