Leading Economic Indicators Continue to Suggest Return to Contraction Is Likely

Includes: DIA, QQQ, SPY
by: Erik McCurdy

The Philadelphia Federal Reserve reported that its manufacturing diffusion index increased to -0.7 in September from -7.7 in August:

The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, increased from a reading of -7.7 in August to -0.7 in September. The index, which has been negative for two consecutive months, suggests that growth has stalled over the last two months (see Chart). Indexes for new orders and shipments continued to indicate weakness this month: The new orders index fell 1 point, remaining negative for the third consecutive month, and the shipments index decreased 3 points, remaining negative for the second consecutive month.

Firms reported near steady employment this month but lower average work hours for existing employees. The percentage of firms reporting increases in employment (18 percent) narrowly edged out the percentage reporting decreases (16 percent). The index for employment was slightly positive this month, increasing 5 points from its negative reading in August. Indicative of weaker activity, more firms reported declines in average work hours for existing employees (30 percent) than reported increases (8 percent).

Although the index moved higher this month, the rebound follows a sharp decline from more than 20 earlier this year as shown on the following graph from Calculated Risk.

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Many leading economic indicators continue to suggest that a return to contraction is likely during the next two quarters. The following graph from Hussman Funds compares a weighted average composed of the ECRI Weekly Leading Indicator and the Philadelphia Federal Reserve diffusion index to the ISM Purchasing Managers Index (PMI).

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The weighted average has forecast the direction of the PMI with great accuracy over the past 40 years and it currently suggests that the index will move into negative territory sometime during the next few months. The following three graphs are courtesy of Albert Edwards at Societe Generale. The first one compares a composite of all PMI leading indicator components with the headline index value.

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The precipitous decline in the leading indicator composite also suggests that the PMI will likely drop below the 50 level during the next several months. The next graph compares the work week metric from the Philadelphia Federal Reserve to the PMI.

Again, we see another sharp decline in the work week data during the past several months, predicting a similar drop in the headline PMI moving forward. Finally, the following graph compares US analyst optimism with Earnings Per Share (EPS) growth.

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The sharp decline in analyst upgrades since the beginning of the year suggests that EPS growth will slow dramatically during the next two quarters. Nothing is certain, of course, but when so many historically realible leading indicators signal that a return to economic contraction is likely, it is prudent to prepare for renewed weakness.

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