Recession Watch: Keeping an Eye on the Leading Economic Index

by: Richard A. Anderson

Last year, there were eight trading days where the S&P 500 moved up or down by at least one percent. So far this year, there have been forty-one such trading days. Further, five of the last eight trading sessions have seen the S&P 500 move up or down by at least one percent. The recent volatility in the stock market has some asking what's next for the stock market and the U.S. economy.

We are currently in the second longest economic expansion in the history of the United States. While this places the economic expansion in the history books for its longevity, this has also been the shallowest economic expansion. As of June 30, 2018, the economic expansion that started in June 2009 following the Great Recession has only resulted in cumulative GDP growth of 20%. For comparison, the longest economic expansion, which lasted from March 1991 through March 2001, had cumulative GDP growth of 35%.

Given the recent concerns that the Fed may raise interest rates too quickly and stifle economic growth, which could potentially lead to the next recession, we thought this would be a good time to review one of the key economic indicators we monitor to provide some insight on where the economy stands.

The Conference Board Leading Economic Index® (LEI) is one of our favorite economic indicators. The LEI is designed to signal peaks and troughs in the business cycle based on a composite of ten economic indicators whose changes tend to precede turns in the overall economy. The ten components of The Conference Board Leading Economic Index® for the U.S. are:

· Average weekly hours, manufacturing

· Average weekly initial claims for unemployment

· Manufacturers’ new order, consumer goods and materials

· ISM® Index of New Orders

· Manufacturers’ new orders, nondefense capital goods excluding aircraft orders

· Building permits, new private housing units

· Stock prices, 500 common stocks

· Leading Credit IndexTM

· Interest rate spread, 10-year Treasury bonds less federal funds

· Average consumer expectations for business conditions

Using a composite of the ten components rather than focusing on just one reduces the risk of false alarms and predicts common turning point patterns in a more convincing manner.

When the most recent data for September was released last week, the LEI rose 0.5% month-over-month and 7.0% year-over-year. This is a positive signal for future economic growth. Looking beyond the most recent data, the LEI has been positive or flat for 28 consecutive months, which is the longest streak without a drop since the mid-1980s.

This is important because the LEI has been very successful at forecasting recessions. In fact, the LEI turned negative year-over-year prior to all seven recessions since 1970. The chart below shows the LEI turned negative year-over-year on average eight months before a recession.

10222018_Leading Economic Index.png

We should note, however, that while the LEI is a great predictor of economic growth there is no relationship between the movement of the LEI and future stock market performance.

With the LEI up 7.0% year-over-year, this economic indicator suggests a recession is not in sight. At this point, only two of the component indicators, average weekly hours and building permits, are sending caution signals. We will continue to keep a close eye on the LEI in the months to come.