Intro: Not all economic indicators are created equal when it comes to their usefulness in predicting economic inflection points. Leading indicators such as profit margins, equity prices, and the yield curve tend to provide a useful guide to future changes in real GDP growth, while income and employment data merely reflect economic changes which have already occurred.
To understand what drives cyclical changes in real GDP growth, it is important to distinguish between leading, coincident, and lagging indicators. Most economic commentators tend to view the most recent data point as the most important in terms of its information regarding the state of the economy. Little attention is paid to the quality of an economic indicator in terms of its tendency to predict future economic growth rates, which is ultimately what we are trying to do.
For instance, a strong rally in the stock market over the past month is likely to be much more informative about the outlook for economic growth than a spike in the unemployment rate. The former reflects improving near-term economic confidence while the latter reflects the lagged impact of economic weakness that actually occurred several months ago.
Because economic growth tends to be relatively stable in most economies, economists often simply extrapolate the ongoing trend. However, at economic turning points, leading indicators are invaluable in predicting when an economy is likely to rebound from a downturn or slump following a boom. The fact that the vast majority of economists fail to predict economic turning points is testament to the lack of understanding of leading indicators, not to mention other factors such as career risk (it is safer to be wrong along with everyone else than risk being wrong on your own).
There are various leading indicators of economic activity, some of which are considered ‘long-leading’ such as corporate profits and the yield curve, which tend to turn lower many months on advance of economic weakness and vice versa. Shorter-term leading indicators such as the stock market and manufacturing surveys are more prone to turn down immediately prior to economic weakness and vice versa. It is important to keep in mind that there are no ‘silver bullet’ economic indicators and it usually takes several indicator signals to suggest a turning point in the economy.
Corporate Profits: Changes in corporate profits are a reliable signal of changing economic growth rates over the proceeding 12-24 months. Declining profit growth represents declining productivity and signals to business reduce expansion plans.
Yield Curve: The spread between longer-term bond yields and shorter-term bond yields is also a long-leading economic indicator. When long-end yields fall below the level of short-end yields it tends to indicate fears over the sustainability of the economic expansion.
Equity Prices: Equity market moves are important leading indicators of the business cycle. Despite the old adage that the equity market has predicted nine of the last five recessions – a point made to indicate that equity market declines are regularly shrugged off by the real economy – very few economic slumps have occurred without their being prior equity market weakness. As with many leading indicators, equity market moves are a necessary but not sufficient condition for economic weakness.
Manufacturing Survey Data: Despite claims that manufacturing is no longer as important as it once was given its diminishing share of GDP, it is still a key leading indicator of the business cycle. Survey data showing a pick-up in new orders or a decline in inventory tends to indicate a pick-up in subsequent production in the months ahead and vice versa.
Confidence Surveys: Recessions and recoveries tend to be preceded by a sharp drop and sharp rise in business and consumer confidence. In the case of a recession, falling confidence reflects a likely change in the behavior of consumers and business towards more conservative purchasing and investment decisions, signaling a slowdown in economic activity.
Construction Permits: Construction permits precede actual construction spending and given the importance of construction as a driver of changes in real GDP it is seen as a leading indicator of the economy at large.
Terms of Trade: Changes in terms of trade – the price of a country’s exports relative to the price of its imports – can have an important impact on subsequent economic activity, particularly in countries with large imports or exports of commodities. A sharp drop in oil prices will tend to undermine the ability of an oil exporting country to generate growth over the subsequent months and quarters. (see ‘How Terms of Trade Changes Impact Economic Growth‘).
Coincident, Lagging Indicators
Coincident indicators can be used to confirm that an economic inflection point has arrived but are not particularly useful in their own right. Factors such as personal income and industrial production fluctuate at the same time as real GPD itself and provide little insight into the future. Lagging indicators reflect changes in real GDP growth which have already taken place, typically months prior. The unemployment rate, despite being a keenly watched figure among central bankers, is such a lagging indicator that it actually gives almost zero information about the outlook for real GDP growth. (see ‘The Labour Market is a Lagging Indicator‘).