In early year discussions I commented on thoughts regarding consensus thinking for US GDP growth this year. Call it a 3.5-4% range of possibility. The about face in most Street economist prognostications relative to last summer has been very much dramatic, but easily understandable in light of 1) the magnitude of Fed sponsored POMO activity that began in late August of last year and the ultimate follow on QE2 announcement and implementation, and 2) the tax cut extension legislation that adds an incremental approximate $350 billion of new US government spending/stimulus in the current year. You may also remember that in the summer of last year, weekly leading economic indicators began flashing a warning regarding US economic slowing. No wonder so many folks such as the Goldman economics team were more than downbeat in the summer and early fall of 2010.
But of course since then, in conjunction with the about face in economist forecasts has come a renewed upswing in many a LEI index. I want to spend just a few minutes looking at some historical LEI data so that we can all hopefully benchmark in the current cycle as we move ahead. Important why? Given that consensus thinking is now focused on economic acceleration, implicit in that thinking is that the leading economic indicators should indeed keep powering forward. A fall back or serious decline would be a game changer for the consensus. Although it may never occur, something like this is surely not built into current prices for equities, nor perhaps bonds.
Lastly, as I have likewise mentioned as of late, it's a better than even money bet that a lot of the good news regarding current year GDP growth is already built into financial asset prices given the powerful run in equities since late summer of last year and burgeoning higher Treasury interest rates. I’ve suggested and still believe the most important information we can attempt to anticipate now may indeed be what is to come fundamentally for the economy and corporate earnings in latter 2011 and certainly into 2012. Although this may always be the case, this means watching the LEI numbers will be important. But maybe it's especially important right now based on historical rhythm.
Let's start with a longer-term look at the ECRI LEI numbers. Drawn in is the 120 week MA that at least historically has proven to be a line worth watching. Every official US recession of the last four decades was either preceded by or coincident with the headline ECRI numbers breaking this line to the downside. And that's exactly what we saw last summer prior to the reacceleration upward in the numbers. You'll also see the red circles drawn into the graph. What these represent are periods of temporary LEI weakness following initial LEI acceleration highs in immediate post recession environments. You are probably more than familiar with the term "growth slowdown" or "mid-cycle slowdown". This is exactly what these represent - temporary economic slowing after an official economic recovery has begun. And of course in each cycle investors and economists initially wonder whether this slowing is simply temporary, or the beginning of a renewed downturn that will once again lead to recession. It happens virtually every cycle, as you can see in the chart. In fact the only cycle not to see something like this was the post 1973-74 recession period, which is not marked because of this very fact. Likewise, the slowing in the LEI numbers post the 1980 recession actually did lead to the infamous double dip recession of 1982-83.
So the key issue hopefully applicable to our current circumstances is the fact that these temporary lulls in LEI indicator acceleration in post immediate recession aftermath/initial economic recovery periods is more the rule than the exception. This is the reason why the whole idea of temporary or mid-cycle growth slowdowns has become so popular a construct among the economist crowd. So now that I’ve run through all of this, what do we watch ahead? What are the important benchmark points to our circumstances in 2011?
First, as you can see in the chart above, after these temporary slowdowns came to an end in each cycle, the LEI numbers pretty much in virtually uninterrupted fashion went on really to new cycle peaks that occurred prior to the next recessionary events. There were few, if any, interruptions on acceleration to the next peak. The 1987 market crash got in the way of uninterrupted LEI advancement in the post 1982 economic environment, as did the LTCM debacle in 1998. So as we move ahead, if the US economy is to keep advancing we should expect steady and consistent acceleration in the LEI numbers. Not every single week by any means, but there should be little disturbance in upward trend.
Secondly, it seems important to keep an eye upon just how much time it takes the LEI numbers to best their prior post recession initial acceleration highs. In the table below I’m essentially quantifying what occurred with each red circled example in the chart above. You are looking at the exact week in which the LEI numbers initially peaked post the previous recession, just prior to the supposed mid-cycle slowdown. In English, I’m trying to answer the question, as per the rhythm of the LEI numbers themselves how long did each mid-cycle economic slowdown last in duration?
You already know the sample size is small, so are there definitive conclusions to be drawn here? How about approximations. As is stated, the average "mid-cycle" slowdown as characterized by LEI data was 37.5 weeks as per the historical occurrences documented above. Although we can assure you it's a mere coincidence, we just happen to be there right now. If we removed the 52 weeks experience post May of 2002 from the sample as a bit of an anomaly, the average drops to 32.7 weeks. Anyway, you get the idea. So as we venture into 2011, I'd expect an initial return to the April 2010 LEI highs within another two and one half months at the latest. Moreover, acceleration should not stop there as per the message of historical LEI experience. We should keep moving higher into the next pre recession peak. Again, I think this is very important in the current cycle given my personal belief that the current economic recovery/acceleration for 2011 is still very much "assisted", as opposed to organic.
Before pushing ahead, one last comment to keep in mind. In a discussion last year, I penned a piece entitled "Tell Me Sweet Little LEIs". The upshot of that discussion was the thought that the LEI numbers would indeed accelerate further, as they have, especially given what was to come with QE2. Incredibly prescient on my part? Hardly. The key issue in that discussion was the fact that 50% of the LEI number is driven by three data points that would be heavily positively influenced by the Fed under QE2. Have a quick look at the following chart and I'll briefly explain.
50% of the headline LEI index number is comprised of US stock prices, the money supply and interest rate spreads. As you know, the chart above is nothing more than the ECRI numbers set against the exact same weekly period prices for the S&P 500. Without question, US equity prices have a very significant impact on the rhythm of the LEI numbers. As I've noted in the chart with the small black lines between the LEI and SPX numbers, look how many times meaningful wiggles and jiggles in stock prices were subsequently followed by very much immediate and like directional change patterns in the LEI index numbers. Without question, stock prices are essentially a leading indicator for the leading economic indicator numbers.
And certainly the Fed has positively influenced the money supply numbers with both POMO and QE2 activity over the past five plus months. In no way am I suggesting the influence of equity prices on the LEI numbers is something terrible or misleading. It is what it is. We just need to realize what we are seeing when we look at these numbers and exactly what is influencing or driving direction. By the way, just as an FYI, the remaining 50% of the LEI index is made up of the combination of average weekly hours (manufacturing), non-defense non-aircraft capital goods new orders, ISM new orders, building permits, unemployment claims, ISM supplier deliveries, and consumer expectations. So for now, 50% of the LEI numbers do reflect the reality of the real domestic economy. Yet the remaining 50% (equity prices, money supply and interest rate spreads) very much reflect a reality that has been "created" by the Fed as opposed to being created solely by free market forces.
Bottom line being, for the domestic US economy to forge ahead and justify consensus expectations and current asset pricing, we should expect new highs above the April 2010 level in the LEI somewhere in early to mid 2Q at the very latest. Additionally, we should expect continued advancement in LEI trends beyond reaching new interim highs. Although we still have miles to go at this point, the LEI trend will become a must watch exercise if the Fed truly ends QE2 in June of this year. The LEI litmus test period? It very well could be. Because as you look at the chart above one more time, the LEI trends have traveled a path exactly like stocks in aggregate since March lows of 2009 - advancing under quantitative easing and contracting otherwise. The LEI numbers have followed the Fed, as have equities. As we walk through this year, periodically I'll be reviewing the 50% of the LEI components that represent the real economy only so we can hopefully attempt to strip out the "assistance" being afforded the economy and the markets by the Fed itself. Stay tuned.
