Introduction: What Are The Long Leading Indicators?
I have several systems for forecasting the economy. One is the high-frequency "weekly indicators," which as the name implies is updated weekly, and thus very timely. A second relies on monthly and quarterly data which has been extensively vetted in the past as having a sustained record of turning one year more before the economy as a whole.
For the short term, up to about six months out, the Index of Leading Indicators is a perfectly adequate tool with the inconvenient habit of being right more often than most highly paid Wall Street forecasters. To forecast the period over 6 months out, I turn to long leading indicators.
A "long leading indicator" is an economic metric that reliably turns a year or more before the onset of a recession.
Geoffrey Moore, who for decades published the Index of Leading Indicators and in 1993 wrote Leading Economic Indicators: New Approaches and Forecasting Records, identified 4:
- Housing permits
- Corporate bond yields
- Real money supply
- Corporate profits adjusted by unit labor costs
A variation of the above is Paul Kasriel's "foolproof recession indicator," which combines real money supply with the yield curve, i.e., the difference in the interest rate between short- and long-term treasury bonds. This turns negative a year or more before the next recession about half of the time.
Another long leading indicator has been described by UCLA Prof. Edward E. Leamer who wrote that "Housing IS the Business Cycle." In that article, he identified real residential investments as a share of GDP as an indicator that typically turns at least 5 quarters before the onset of a recession.
Several other series appear to have merit as long leading indicators as well. Real retail sales in several forms also have value as a long leading indicator, and in particular, real retail sales per capita. Additionally, the tightening of credit conditions also appears to have merit as a long leading indicator.
That gives us a total of 8 long leading indicators. All of these economic series have a long-term history of turning a year or more before a recession.
I last did a comprehensive update of these last six months ago, concluding:
“There has been enough further deterioration in the long leading indicators" ... [that it] warrants going on Recession Watch one year out — i.e., beginning Q4 2019.
I subsequently explained that “[a]’Recession Watch’... isn’t a ‘Recession Warning, where a downturn looks certain, but more on the order of” a hurricane watch, where there is a heightened possibility that the condition will occur if conditions persist.
By the end of this year, the weakness in the long leading indicators late last year ought to be exerting maximum pressure on the economy. So far, neither consumers nor producers are buckling, although in the latter case (especially looking at the ISM index and industrial production) the case is close.
Current Trends In The Long Leading Indicators
Corporate Bond Yields:
On a monthly basis, corporate bond yields data goes back 100 years to 1919. With the exception of the 1981 "double-dip," the fiscal contractions underlying the 1938 and 1945 recessions, and 1926, corporate bond yields have always made their most recent low over one year before the onset of the next recession. The below graph shows both AAA and BAA corporate bonds for the last six years, together with 30-year mortgage rates (red):
Here we have just had a very significant development, as both AAA and BAA corporate bonds have now surpassed their 2013 and 2016 lows on a daily and weekly basis (although not yet at least on a monthly basis). Meanwhile, mortgage rates are at 2 1/2 year lows.
Interest rates have turned decisively positive.
If the news on interest rates is decisive, housing data is emphatically conflicting.
In the last few months, housing starts, new home sales, and the less volatile single family permits have all rebounded (in the last case, at least weakly) off their lows:
But total housing permits made a new multi-year low in June:
Further, as of the 2nd quarter of 2019, measured both nominally and in real terms, housing as a share of GDP has continued to decline:
Because the direction of housing tends to follow interest rate with a 3- to 9-month lag, housing is likely to improve over the next six months. Both these would only impact the latter part of 2020. For the first six months, this sector is giving a decidedly mixed signal.
Neither corporate profits nor unit labor costs have been reported for Q2 yet. In Q1, however, they decreased. In the meantime, the placeholder of proprietors income (red) showed a slight increase to a new high in Q2:
Although I won’t show the graph, in the past 4 quarters the deflator of unit labor costs has actually decreased, so if Q2 is like the past year, that new high is likely to stand up.
Further, according to FactSet, reported earnings of the S&P 500 increased significantly in Q2, after declining from Q3 through Q1:
There is some indication, however, via these graph from Scott Grannis and Cam Hui, that NIPA corporate profits may in the past have usually turned several quarters before earnings as reported from the S&P 500:
Pending the report of corporate profits for Q2 in the revised GDP report later this month, this forecast indicator is mixed.
Real Money Supply:
No recession has ever started without at least real M1 turning negative or real M2 declining to under +2.5%. Real M2 crossed this threshold at the beginning of 2018, and during the autumn briefly real M1 came close before turning up just before the end of last year. Since then, both have improved considerably:
Thus money supply has turned positive, especially as we get to midyear in 2020.
The Yield Curve:
This has been an excellent long-range forecasting tool in times of inflation (although, I do not think a positive yield curve is definitive in low interest rate deflationary environments). In the last 60 years, typically a recession has begun after the Fed raises rates to combat inflation, sufficiently so that the yield curve inverts.
This tightened through 2018 and the intermediate portions started to invert on December 4, and have generally remained inverted since. In late May, the 10-year minus 3-month portion also inverted, as shown in red below, although the equally widely watched two year- to 10-year time frame has not inverted:
The closest analogous pattern is that of 1998, which is consistent with a slowdown but not an outright recession. This indicator is therefore also mixed.
The loosening or tightening of credit also appears to be an important component of changes in the economy over one year out. Although it only has a 30-year track record, the Senior Loan Officer Survey is promising. As I reported last week, credit became slightly more goose to both large and small sized firms in Q2, consistent with the weekly Adjusted Financial Conditions Index from the Chicago Fed, shown in red in the graph below:
On the other hand, demand for loans by all sized firms continues to wane, which has also been true for one year or more before each of the recessions in the last 25 years:
As a result, this indicator as well must be judged as mixed.
Real Retail Sales Per Capita:
These peaked more than a year before the onset of the last two recessions.
After a slowdown during the government shutdown, these have rebounded to new highs this spring:
This is a positive indicator.
Summary and Conclusion
Let me point out first of all that this is a more comprehensive set of indicators, and in some cases indicators with a longer and better track record than are found in my more timely “Weekly Indicators” columns.
There are 2 positives: corporate bond yields and real retail sales per capita.
There are 5 mixed indicators: housing, corporate profits, money supply, the yield curve, and credit conditions.
There are no negatives.
This is an improvement from 2 positive, 2 mixed, and 3 negative indicators six months ago. While this is hardly a strong overall picture (and I am still waiting on the quarterly corporate profits report), it suggests that, *left to its own devices,* if the economy has not entered a recession by the end of this winter, it is not likely to, and coincident conditions like production and employment should be improving by midyear next year.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.