Gross Domestic Product (GDP) is a measure of economic activity; the most recent measure was 2.9%1. While this indicates expansion, it’s also backward-looking. As in, GDP is one of several lagging indicators that tell us what has already happened rather than what could happen next. While lagging indicators are interesting from a historical perspective, they tend to offer little to no predictive power. Instead, let’s discuss the top five leading indicators we are watching closely in 2023.
Inflation is a currency phenomenon. It’s too many dollars chasing too few goods. That’s why the chart below is so important2. It shows that M2, which measures how much money is in the “system,” leads the inflation rate. When the money supply rises (blue line), inflation follows (red line).
Back in 2020, the Fed increased the money supply by over 40% in two years and created a lot of inflation. We need a period of below-average money supply growth to get back to normal. The good news is that the blue line is now growing at the slowest pace in four decades.
Inflation does not need to return to 2% before the Fed pumps the brakes. They just need to see inflation solidly moving in that direction, and there’s already plenty of evidence that it’s happening.
The longer the blue line stays where it is now, the faster inflation will get back to normal. This matters because the Fed’s entire monetary policy is centered around bringing down inflation to its target. The more evidence that inflation is moving in that direction, the better the odds that they will stop raising interest rates.
As the length of a loan rises, so does the risk to the lender. The borrower may only pay some of it back, unexpected inflation may eat away at the fixed interest payments years later, etc. Hence, longer-term loans typically have higher interest rates to compensate the lender for the added risk. That’s why most “yield curves” are upward-sloping like this:
However, there are times when longer-term loans are cheaper than shorter-term ones. This is called an “inverted yield curve” and looks like this:
Inverted yield curves are rare, but when they happen, they can become problematic because bank lending is often tied to yield curves. If banks cannot lend at a higher rate than what they pay depositors, they can’t make money. Banks then stop/slow lending, and the economy can fall into a recession if the inversion persists.
Since October, the entire yield curve has been inverted, and the chart below shows that the purple line has fallen below zero (inverted) each time before the last eight recessions (shaded regions); albeit with considerable variation ranging from 12 to 50 months, with an average of 24 months3.
But not every recession can be tied back to an inversion. For example, the 2020 recession technically occurred months after the inversion in August 2019, but neither the inversion nor the drivers of the inversion had anything to do with that recession. It was purely due to the government shutting down the economy.
Said another way, yield curve inversions have predated, not predicted, every recession going back to World War II. However, the drivers of inversions are often the same as those pushing the economy into a recession, so the yield curve should be watched closely.
One of the strongest and most consistent signals of an equity market bottom is manufacturing activity, and the chart below could be the key to determining when both could bottom4. There’s a lot to unpack here, so let’s begin with the mustard-dotted line.
This is the difference between new orders and inventories. A rising line suggests expanding manufacturing activities from either new orders rising and/or inventories falling (more stuff is being sold). A falling line suggests a manufacturing slowdown because new orders are falling and/or inventories are rising (less stuff is being sold). Right now, this line is well below zero – indicating a slowdown.
The blue line is a measure of broad-based manufacturing activity – not just orders and inventories – with a lag of three months. Notice how they move in lockstep.
In English, the mustard line predicts the blue line's future direction by three months. Since the blue line is what has predicted equity market bottoms, then by association, the mustard line could help us predict the timing of an equity market bottom. There’s been a recent uptick in the mustard line, but not yet enough to confidently say that the trend has reversed.
If inflation can continue to fall without causing too much damage to employment, then the Fed may be able to avoid a recession (aka “soft landing”). The key to success lies in the chart below. When the purple line is above the blue line, “real” wealth is created because wages grow faster than inflation. But when the blue line is above the purple, wealth is destroyed.
As the saying goes, it’s not how much you earn but how much you keep. Inflation is a tax, so workers have seen less since the two lines intersected back in March 2021. The Fed’s goal right now is to revert this trend and get that purple line back on top. That would indicate prosperity is returning to the American consumer.
There’s another issue with wage growth below inflation. It’s also inflationary because rising inflation pressures workers to make more money. They'll look elsewhere if their bosses don’t pay more to keep them around. Since employees tend to be the largest or second largest expense for companies in the U.S. (we are a services-based economy), rising wages eventually get passed along to consumers.
Said another way, inflation begets more inflation. The Fed knows this, and that’s why so much of its focus right now is placed on the labor market. The good news is that this gap is closing, and if this trend persists, a soft landing will become more probable.
The U.S. economy is almost 70% consumer spending1. Pay for a haircut or go see a movie, and the economy is growing. The Census Bureau reports retail sales data monthly, and it acts as a key economic barometer. It helps us gauge the economy's health and assess the impact of inflationary pressures.
Not only are retail sales a strong indicator, but it’s also one of the timeliest because it provides data that is only a few weeks old. Over the past three months, it’s indicated an overall slowdown but also a shift back to services from goods (no more spending stimulus checks on new TVs and handbags).
This is important because of retail sales’ inextricable tie to inflation and Fed policy. Slower retail sales should help quell inflation and persuade the Fed to dial down its aggressive monetary policy.
The Bottom Line
This list is by no means exhaustive. There are several other leading indicators, and while their predictive powers vary, each has limitations. No single indicator is a trigger switch, nor can they stand on their own.
Believe me, I wish they could. If the economy was that formulaic, my job would be much easier. But economies are fueled by human behavior, and since that’s pretty much impossible to model in Excel, outcomes are never certain. Yield curves invert and don’t predict recessions, rising interest rates don’t always dampen demand, and high inflation doesn’t always lead to a slowdown in retail sales. That’s why we look at so many indicators together.
Add it all up today, and these imply a slowing economy but also one that could avoid a recession if the Fed pumps the brakes before employment falls apart. If someone gets laid off, they tend to buy less stuff, and that hit to consumer spending can cause other people to get laid off. Once this momentum builds, it is hard to reverse. The fed slowing its pace of rate hikes this week is a good next step to that soft landing.
The bottom line is that markets are accountable to Darwin, not Newton. They are not bound to the laws of physics, nor do they always operate predictably. But leading indicators like the ones above can provide insight into what could happen next. We use these along with strict risk controls to position our portfolios through the good and bad times.
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.