I recently wrote an article entitled "The Most Important Economic Number" which discussed the often overlooked, but very important, message that the Chicago Fed National Activity index tends to deliver. In that article I stated that the index is a composite made up of 85 subcomponents which gives a broad overview of overall economic activity in the U.S. However, unlike backward-looking statistics like GDP, the CFNAI is a forward looking metric that gives some indication of how the economy is likely to look in the coming months. Importantly, understanding the message that the index is designed to delliver is critical. From the Chicago Fed website:
"The Chicago Fed National Activity Index (CFNAI) is a monthly index designed to gauge overall economic activity and related inflationary pressure. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth."
The overall index is broken down into four major sub-categories which cover:
- Production & Income
- Employment, Unemployment & Hours
- Personal Consumption & Housing
- Sales, Orders & Inventories
To get a better grasp of these four major sub-components, and their predictive capability, I have constructed a 4-panel chart showing each of the four CFNAI subcomponents compared to the four most common economic reports of Industrial Production, Employment, Housing Starts and Personal Consumption Expenditures. To provide a more comparative base to the construction of the CFNAI I have used an annual percentage change for these four components.
The correlation between the CFNAI subcomponents and the underlying major economic reports do show some very high correlations. This is why, even though this indicator gets very little attention, it is very representative of the broader economy. Currently, the CFNAI is not confirming the mainstream view of an "economic soft patch" that will give way to a stronger recovery by year end.
With this background we can update our analysis for the most recent release.
The July report showed some minor improvements in the underlying data which is more consistent with a bounce in activity as inventory levels become depleted, pent up demand is filled and seasonal biases come into effect. However, while the July report showed an improvement in economic activity rising to a -0.15 in July; that improvement only occurred because June was revised down from -0.13 to -.23. In other words activity remains essentially at the same level that it appeared last month.
However, as I stated above, there was some improvement in the underlying data with 3 or the 4 sub-indexes gaining ground. Not surprisingly, after several months of bleed off, inventories gained some ground as restocking took effect heading into the back-to-school shopping season. This indicator improved to a +0.04 versus June's read of -0.07. The consumption and housing index improved to a -0.15 from last month's read of -0.20 which still shows below average growth in consumption and housing which has been evident with the slowdown in housing due to the rapid increase in interest rates and slower rates of consumption growth. Employment also improved marginally to a +0.6 from +0.5 last month which denotes employment growth above the long term average. However, it does not distinguish between "quantity" and "quality" of employment. As we discussed previously - temporary hires do not lead to stronger long term economic growth which is why the unemployment rate as it is reported is irrelevant.
The one component of the four that turned in a further negative reading was in the production related indicators which slipped further into negative territory falling to a -0.10 from the previously report -0.01. The decrease in manufacturing activity is concerning given the hopes of increased economic activity by year end. The chart below which shows the CFNAI index as compared to its 3-month moving average confirms that the current bout of sluggish economic activity is not set to dissipate currently.
While the CFNAI's current level is still consistent with economic growth it does not suggest that growth will sharply accelerate in the second and third quarters of this year. At this juncture, with 1.4% growth through the first half of the year, it will not be surprising to see growth for the year remain below 2%. This will be far below the Federal Reserves current estimates of 2.5%.
This last statement is key to our ongoing premise of weaker than anticipated economic growth despite the Federal Reserve's ongoing liquidity operations. The current trend of the various economic data points on a broad scale are not showing indications of stronger economic growth but rather a continuation of a sub-par "muddle through" scenario of the last three years.
While this is not the end of the world, economically speaking, such weak levels of economic growth do not support stronger employment, higher wages or justify the markets rapidly rising valuations. The weaker level of economic growth will continue to weigh on corporate earnings which, like the economic data, appear to have reached their peak for this current recovery cycle.
The CFNAI, if it is indeed predicting weaker economic growth over the next couple of quarters, also doesn't support the recent rotation out of defensive positions into cyclical stocks that are more closely tied to the economic cycle. The current rotation is based on the premise that economic recovery is here, however, the data hasn't confirmed it as of yet.
The reality is that either the economic data is about to take a sharp turn for the positive or the market is set up for a rather large disappointment when the expected earnings growth in the coming quarters doesn't appear. From all of the research that I have done as of late, it is the latter that seems the most likely of outcomes as there does not seem to be a driver, currently, for the former. Maybe the real question is why we aren't paying closer attention to what this indicator has to tell us?
Source: Street Talk Live
