Overview:
- US and global growth is stabilizing, alleviating fears of a US recession
- LEIs suggest we see higher growth, higher interest rates & inflation into year-end
Business cycles are largely non-linear affairs. There are times when the economy may accelerate or decelerate, much like a car constantly varying in speed even though it is still moving forward. You may think that sounds intuitive, but translate that into rates of economic growth and we all get confused, often mistaking decelerations in positive growth for imminent signs of driving in reverse—that is, recessions, crashes, or worse.
Since asset classes and sector returns are largely impacted by such changes in the economy, one of my main objectives as an investor is identifying these key turning points. At Financial Sense, the most reliable tools we've found over the years for doing this are leading economic indicators (LEIs).
Two of the more widely known LEIs are the yield curve and stock prices since both have traditionally done a good job at predicting major turning points. One LEI that is less widely known is the use of the relative performance of early to late-stage cyclical stocks. Cyclical stocks are those that are highly sensitive to moves in the economy like an industrial company, say General Electric (GE), an energy company like Exxon Mobil (XOM), or consumer stock like Nordstrom’s (JWN). On the flip side, non-cyclical stocks are less dependent on the business cycle and can be a consumer staples company like Johnson & Johnson (JNJ) or health care company like Pfizer (PFE).
Going even futher, within cyclical sectors of the market there are those that react early to changes in the business cycle while others that outperform near the end. As I've shown in the past, tracking the relative performance between these two areas can be used to predict economic turning points and was one of the tools I used near the start of the year (see here) to claim that global growth would likely bottom in the spring and, implicitly, that the US would not tip into recession.
When we look at the evolution of global GDP forecasts, that call did play out accordingly with February/March serving as the low point. Since that time, economists have had to raise forecasts as incremental global GDP data has stabilized and titled more positive. Coinciding with the trough in economic growth estimates was a peak in the USD (shown inverted below) and should global growth continue to improve the USD’s sharp advance over the last year should cool.
Source: Bloomberg
Confirming the improved global growth outlook are the global LEIs from the Conference Board in which 10 out of 13 global LEIs improved last month.
Source: The Conference Board
According to The Conference Board, their LEI for Europe remains on an upswing since 2013 and argues for Europe to continue to add to global growth.
Source: Conference Board
Looking at the US there are 17 different LEIs that I track. Below is a diffusion index showing the percentage that are showing positive growth (focus on level of growth) as well as the percentage that are showing accelerating growth (focus on growth rate). We do appear to have reached an inflection point in growth as the percentage of LEIs showing positive growth has bottomed and turned up concurrent with the uptick in the ISM Purchasing Managers Index (PMI, shown in red below).
Source: Bloomberg
We are likely to continue to see more LEIs move into positive territory given momentum for growth is accelerating as my diffusion of US LEIs showing accelerating growth has bottomed.
Source: Bloomberg
Circling back to the message from the relative performance of early to late-stage cyclicals, I wrote last month that the biggest inflection point of the year was happening (click for link) and I used the following chart to make a call for an uptick in the ISM PMI:
Source: Bloomberg
Right on cue, the ISM PMI suprised to the upside and the relative performance of early to late-stage cyclicals has continued to advance to the highest level since 1999, arguing for the US manufacturing sector to pick up well into the end of the year.
Source: Bloomberg
Confirming the trough in US economic growth is the Economic Cycle Research Institute's Weekly Leading Index (WLI), which not only has clearly bottomed but is now back into positive territory.
Source: ECRI
The upturn in LEIs and the ECRI’s WLI suggest the US economy is not slipping into recession as some have argued given the recent weak GDP data. As in prior years the weak Q1 GDP print is likely to be a temporary blip as the trend growth rate for the US economy remains up and other indicators are simply not validating the Q1 dip in GDP. One such data point is the annual growth rate in vehicle miles driven. If economic activity were slowing we would not see more cars and trucks on the road and currently we are seeing the strongest growth in miles driven since January 2007. Given their close relationship (see below), that argues for a pickup in GDP ahead.
Source: Bloomberg
With both US and overall global economic growth expected to pickup over the coming months, it’s not surprising to see a jump in interest rates recently. I touched upon this in an earlier article (see last figure in article, click for link) in which I showed that interest rates were likely to move higher. Based on early to late-stage cyclical relative performance we are likely to see a trend of higher interest rates and higher inflation throughout the remainder of the year and the trend higher in rates is occurring right on cue.
Source: Bloomberg
Source: Bloomberg
Summary
The message coming from the early to late-stage cyclical relative performance for both the US and the globe argued for a bottom in growth this spring, which appears to have arrived on schedule. Growth rates are starting to turn back up after decelerating for several months and we are also likely to see a pickup in inflation and interest rates. There appear to be two wild cards holding back equity markets, which are the ongoing Greek debt saga as well as the debate around when the US Fed will raise interest rates. The uncertainty behind these two issues will likely keep equity markets in a holding pattern but at least it appears the global economic backdrop is improving, which should soften any market decline if it were to occur. The overall trend in higher economic growth should lead to better performance by assets and sectors geared towards global growth like energy, industrials, basic materials, and commodities and should be watched closely to confirm the incoming economic data.
