Leading indicators and what they tell us

Philipp Wörz of Alphen Asset Mangagement writes on economic indicators and what they tell us. He says that 2010 will be a year of economic recovery, both globally and locally. The question that remains to be answered is how sustainable and prolonged it is going to be, especially since broad stock market valuations appear to be discounting a fairly robust recovery.

Leading indicators are used to signal new phases of the business cycle and they generally change before the economy does. Bond yields, the monetary base, stock prices, inventory changes, building permits and the index of consumer expectations, amongst many more, are popular leading indicators. A rise in the indicators mentioned would usually precede economic expansion.

Coincident indicators, as the name implies occur approximately at the same time as the conditions they signify, thereby providing information about the current state of the economy. Gross Domestic Product (GDP), personal income, industrial production and retail sales are popular coincident indicators.

Lagging indicators are used to summarize past economic events. The most popular lagging indicators include the unemployment rate, job creation, corporate profitability and per unit labour costs. As an example, employment tends to increase two to three quarters following the end of the downturn.

Equipped with the knowledge of what these indicators represent, it is particularly interesting to look at the Economic Cycle Research Institute's (ECRI) leading, coincident and lagging indicators, which have been a particularly good source for predicting business cycle trends in the US. 

As can be seen in the chart, the leading indicator is pointing to the biggest bounce back since the 1970s but seems to have topped out in recent weeks.  As a word of caution, however, the strong rebound in the leading indicator can partly be attributed to the massive expansion of the monetary base that the financial crisis brought about, which is not necessarily expansionary. Additionally, in a period of artificially low short term interest rates, the yield curve has to be upwardly sloping, as the Fed simply cannot cut rates any further.  Stock prices, which tend to anticipate an economic recovery and changes to inventories, also recovered from a low base in 2009.

Coincident and lagging indicators seem to confirm the bounce in the leading indicator as they are currently signaling an improving economic environment. Of the two, lagging indicators will need to be watched closely, as any sustained economic recovery will need to be backed up by increased job creation and falling unemployment.

While on the topic, it is interesting to note that South Africa's leading and lagging indicators seem to be trailing the rest of the world in typical fashion. While the leading indicator is also signaling vastly improved conditions, the lagging indicator still has to confirm the end of the downturn.

In summary, while all indicators point to a significant recovery after the global financial crisis and hence a brighter future, the sustainability of a global economic recovery will be closely monitored and some caution is warranted.