Leading Economic Indicators and the Stock Market

2022 was a good year for macroeconomists. Inflation was up, interest rates were finally something people cared about again, and betting on a recession was rivalling sport.

Interest in macro topics was so high that macroeconomists may have finally found themselves the centre of the dinner party.

We haven’t talked about macroeconomic topics like this since the onset of the pandemic and the global financial crisis.

And if you look at Google Trends, we seem to be talking about these topics more than ever:

But is any of that talk insightful? Or is it all hot air?

Economic indicators

People don’t talk about macroeconomics at dinners or the watercooler for the sake of the concept.

Inflation and interest rates are interesting mainly because of their consequences. We discuss them because we want to know what they mean for our future.

The future of our savings, our mortgages, our purchasing power, our portfolios.

We want to anticipate where inflation and interest rates are heading so we can prepare. But anticipating macroeconomic events is hard.

Leading indicators are noisy and laggy.

But some indicators are useful. Central banks must base their decisions on something.

So what indicators are sound?

Take the Conference Board (CB), a not-for-profit research organisation dealing in essential economic data.

CB publishes its Conference Board Leading Economic Index (LEI), a useful resource for researchers and private industry alike.

Last week, it updated its index for the US.

While US stocks have started 2023 strongly, CB’s US LEI is flashing red, with CB’s Senior Director Ataman Ozyildirim writing:

‘The US LEI fell sharply again in December—continuing to signal recession for the US economy in the near term. There was widespread weakness among leading indicators in December, indicating deteriorating conditions for labor markets, manufacturing, housing construction, and financial markets in the months ahead. Overall economic activity is likely to turn negative in the coming quarters before picking up again in the final quarter of 2023.’

Interestingly, CB’s LEI for Australia is holding up better.

In the latest update, most of the LEI components ‘contributed positively’ (albeit, the data is a month behind):

But is the economic data released by CB really that useful? Are its leading indicators sufficiently ahead of the curve?

After all, who hasn’t heard the US is heading for recession?

Bloomberg’s John Authers presented the sceptic’s view last week:

‘[CB’s LEI] aren’t so much leading indicators as concurrent ones. They drop more or less exactly in line with a fall in the economy. So it’s not as though these are much use in showing the way. Not only that, but at the point of publication, they’re actually lagging information. All the components have already been announced. The Conference Board’s role is merely to smoosh the numbers together into an index, using a public methodology. Back in the 1950s, when investors were still using slide rules, this was a useful service. Now, anyone with an interest can calculate the LEI in advance.’

When Authers asked Renaissance Macros Neil Dutta whether LEIs like CB’s still move the market, Dutta responded:

‘It moves bearish people on Twitter. That’s all.’

Ouch.

Authers does say ‘there should still be a payoff for paying attention to the signals the economy and markets are sending as plenty of others aren’t’.

You can pay attention to the key drivers of any economy yourself without subscribing to premium data services.

Here’s a section from my old macro textbook outlining a DIY approach to monitoring the economy:

‘If you want to be able to say more than “the economy is good/the economy is not so good”, you need to understand and be able to analyse these six variables:

• Real gross domestic product
• The unemployment rate
• The inflation rate
• The interest rate
• The level of the stock market
• The exchange rate

‘The first two are the most important: They are directly and immediately connected to people’s material well-being.’

And here’s a clue to the current market bullishness: while the rate of inflation and interest rates are important, it’s unemployment and real GDP that matter most.

And unemployment in the US and Australia is still historically low, despite everything.

As Bank of America’s Matthew Diczok noted last week, even though the yield curve is flashing ‘RECESSION’, the strong labour market tells a different story (emphasis added):

‘The read-across is similar to all other risk asserts. This is because when the macro diverges, follow the labor market. As long as that doesn’t crack, we can stay at elevated valuations vs recessionary readings.’

Economic indicators and the stock market

But why should you, as an investor, pay attention to macroeconomic variables?

The stock market is part of the economy but not the economy. Indicators that may foretell something in the wider economy need not of necessity foretell anything in the stock market.

If a steeply inverted yield curve presages a recession, what does that mean for the stock market? And why should you care?

If you’re heavily invested in the stock market itself via a broad index, then maybe you’ll be uneasy about a looming recession.

A wide economic slowdown is likely to percolate through a broad market index through a dampened earnings outlook.

But does a worsening economy spell doom for all stocks?

If you’re a stock picker, the machinations of the stock market as a whole concern you less than the machinations of individual businesses.

In his November 2022 memo, Oaktree Capital co-founder Howard Marks put it thus:

‘I think most people would be more successful if they focused less on the short run or macro trends and instead worked hard to gain superior insight concerning the outlook for fundamentals over multi-year periods in the future.’

That said, the wider economy is partly linked to the stock market via central banks. Monetary policy isn’t aimed directly at the stock market, but it does spill over.

Ben Bernanke, the latest Nobel laureate in economics and former (controversial) head of the US Federal Reserve, analysed in a highly cited paper the effect of monetary policy that took the market by surprise.

Bernanke found the effect on the stock market was of a ‘reasonable size’.

Why?

Bernanke wrote:

‘The results presented in this paper showed, perhaps surprisingly, that the reaction of equity prices to monetary policy is, for the most part, not directly attributable to policy’s effects on the real interest rate. This finding is the result of the relatively transitory movements in real interest rates induced by surprise policy actions. Instead, the impact of monetary policy surprises on stock prices seems to come either through its effects on expected future excess returns or on expected future dividends.

‘Taken literally, this result suggests that tight money (for example) lowers stock prices by raising the expected equity premium. This could come about in at least two ways. First, tight money could increase the riskiness of stocks directly, for example, by raising the interest costs or weakening the balance sheets of publicly owned firms. Second, tight money could reduce the willingness of stock investors to bear risk, for example by reducing expected levels of consumption or because of its association with higher inflation.’

But Bernanke did allude to an earlier point — that the stock market is not a homogenous entity but a ragtag collection of thousands of businesses:

‘Stocks are claims to real assets, so…stock values should be independent of monetary policy in the very long run. In the medium term, however, real and nominal volatility induced by the form of the monetary policy rule may well influence stock values.’

Stocks are claims to real assets. And how these assets perform in the long run depends less on macroeconomic forces and more on the fundamentals inherent to the asset itself.

I’ll leave the final word to Marks, taken from the same memo (emphasis added):

‘Stop trying to predict the macro; study the micro like mad in order to know your subject better than others. Understand that you can expect to succeed only if you have a knowledge advantage, and be realistic about whether you have it or not. Recognize that trying harder isn’t enough. Accept my son Andrew’s view that merely possessing “readily available quantitative information regarding the present” won’t give you above average results, since everyone else has it.’

Regards,

Kiryll Prakapenka,
For Money Morning