Beyond the yield curve: Other economic indicators to watch

Weekly Market Compass: These metrics can provide a bigger picture of the US economy, but tariffs remain the ‘wild card’

Last week, the US Treasury yield curve, specifically the spread between the 10-year US Treasury rate and the 2-year US Treasury rate, briefly inverted. An inverted yield curve is considered to be a good predictor of recession, and so markets sold off on fears that a recession will occur in the next year. However, I believe a US recession is not a foregone conclusion — and so we should monitor the economic data closely. I have received a number of questions from clients and the media about what other indicators to follow to help divine how the economy is doing. The following are just a few indicators to watch — and some caveats:

 Four economic indicators to watch

1.     The price of copper. This metric, informally known as “Dr. Copper,” has traditionally been considered a good indicator of global economic conditions because copper is an industrial metal utilized in construction and many other finished products. The conventional wisdom is that in an economic expansion, copper is in higher demand and therefore the price rises; in an economic downturn, copper is not utilized as much and the price declines. The price of copper has declined significantly in recent months, but it’s important to recognize this is a global economic indicator, so it doesn’t necessarily mean the US economy is slowing — although given the interconnectedness of the global economy, I believe a slowdown for major foreign economies is likely to cause a slowdown for the US economy.

 2.     ISM Manufacturing and Non-Manufacturing Indexes. These purchasing manager surveys are considered to be fairly good leading indicators for the US economy and useful gauges of turning points in the business cycle. For the ISM Manufacturing Index, a headline number above 50 is consistent with a manufacturing expansion, and a headline reading below 50 is consistent with a manufacturing contraction. It is also worth noting that a reading below 43 for an extended period of time is consistent with an overall economy in contraction. For the ISM Non-Manufacturing Index, a headline reading above 50 is consistent with a non-manufacturing sector expansion, and a reading below 50 is an indicator of a non-manufacturing sector contraction. It is worth noting that the Institute for Supply Management (ISM) asserts that a reading below 48.7 over an extended period of time generally indicates a contraction of the overall economy. The most recent readings for these indices are 51.2 for the July ISM Manufacturing Index and 53.7 for the July ISM Non-Manufacturing Index.1 Both are in expansion territory, although they have been declining in recent months.

3.     The consumer expectations gap. Consumers are such an important part of the US economy, representing approximately 70% of gross domestic product (GDP),2 so any gauge of consumer sentiment or spending is important. However, the consumer expectations gap — the spread between current sentiment and expectations — is viewed as a very accurate harbinger of an impending economic slowdown. If the future is considered less bright than the present, then that is cause for concern; the wider the gap, the more concerned we should be. In recent months, while headline consumer confidence has remained strong, the spread between current sentiment and expectations has become relatively wide for the University of Michigan Consumer Sentiment reading, which is a meaningful negative signal we should follow closely.

4.     The Composite Index of Leading Economic Indicators. The Conference Board puts out this holistic index of 10 different components that help assess and predict the economic outlook: average weekly manufacturing hours worked, average weekly initial unemployment claims, manufacturers’ new orders for consumer goods and materials, ISM Manufacturing New Orders Index, manufacturers’ new orders for nondefense capital goods, new residential building permits, the S&P 500 Index, the inflation-adjusted money supply (M2), the spread between long and short interest rates (the 10-year US Treasury and the federal funds rate), and consumer sentiment. For June, this index declined slightly to 111.5.3 This was the first decline since December and suggests slower growth in the back half of 2019, but not a recession.

The ‘wild card’ in the recession equation: Tariffs

While the above indicators can help provide a bigger picture of the state of the US economy, it’s critical to point out that, because of the escalating tariff wars, we are in unknown territory.

The strongest economies can become vulnerable to recession as a result of protectionist policies and trade wars. (For example, in 1929, before the Smoot-Hawley Tariff Act went into effect and before the Great Depression hit its peak, the US economy enjoyed 6% GDP growth and 3% unemployment.4) That’s because tariffs can have a number of negative effects, most significantly economic policy uncertainty.

Last week, the Reserve Bank of Australia (RBA) Deputy Governor Guy Debelle was emphatic in positing that the US-China trade dispute is causing significant damage worldwide because of the economic policy uncertainty it is creating. He explained the severity of the situation: “On the tariff side, the prospect of a 25% tariff is a first-order consideration in determining whether to invest in a new factory or new machinery and where to locate that investment. Businesses are waiting to see how the uncertainty resolves rather than invest. The longer businesses hold off, the weaker demand will be, which will further confirm the decision to wait. That runs the risk of a self-fulfilling downturn.”5

That’s why I also like to look at metrics that I believe can help determine the impact of tariff wars and economic policy uncertainty (some of which are components of the Leading Economic Indicators Index): CEO confidence, small business expenditure plans from NFIB (National Federation of Independent Business), and capital goods orders — all of which have shown weakness in recent months. The Economic Policy Uncertainty Index and the ISM Manufacturing New Orders Index are other metrics to follow in helping to ascertain the impact of economic policy uncertainty, and both are indicating a pickup in uncertainty.

Recession does not appear imminent

While these indicators have been on the decline and are clearly illustrating the impact of the ongoing tariff wars, none are signaling an imminent recession. And the US consumer remains strong, as evidenced by strong July retail sales, which rose 0.7% — far better than forecast.6 This is important given that the US economy is largely consumer-driven.

While the consumer is still strong currently, we have to pay attention to consumer sentiment, which is signaling a warning. Last week, we learned that overall US consumer sentiment fell to 92.1 in August, the lowest reading since the start of 2019.7 According to a statement from the University of Michigan, “Consumers strongly reacted to the proposed September increase in tariffs on Chinese imports.”

Investment implications

The good news is that, although the economy is slowing, central banks are being proactive. In just the last week, several central banks, including the Reserve Bank of India, cut key rates. While I am not confident that central bank accommodation can reverse damage created by tariffs, I am confident that central bank policies will help support risk assets even as the global economy decelerates. I could envision a scenario in which the economy decelerates, but stocks and other risk assets perform relatively well. I believe that investors with longer time horizons are likely to benefit from staying the course — remaining well diversified and exhibiting intestinal fortitude in the face of unnerving headlines.

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1 Source: Institute for Supply Management

2 Source: Bureau of Economic Analysis

3 Source: The Conference Board

4 Sources: US Census Bureau; Louis Johnston and Samuel H. Williamson, "What Was the U.S. GDP Then?" Measuring Worth, 2019.

5 Source; Reuters, “Sino-U.S. trade dispute risks self-fulfilling downturn: RBA,” Aug. 14, 2019

6 Source: US Commerce Department

7 Source: The University of Michigan Consumer Sentiment Index.

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An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

Spread represents the difference between two values.

The federal funds rate is the rate at which banks lend balances to each other overnight.

M2 is a measure of the money supply that includes cash and checking deposits as well as savings deposits, money market securities, mutual funds and other time deposits.

The ISM Manufacturing Index, which is based on Institute of Supply Management surveys of manufacturing firms, monitors employment, production inventories, new orders and supplier deliveries.

The ISM Non-Manufacturing Index, which is based on Institute of Supply Management surveys of non-manufacturing supply executives nationwide, monitors business activity, new orders, employment and supplier deliveries.

 The ISM Manufacturing New Orders Index, which is based on Institute of Supply Management surveys of manufacturing firms, monitors the level of new orders across several industries in the manufacturing sector.

 The Composite Index of Leading Economic Indicators, published by the Conference Board, tracks 10 different components that help assess and predict the economic outlook

 The University of Michigan Consumer Sentiment Index is published each month by the University of Michigan as a gauge of consumer sentiment.

 The S&P 500? Index is an unmanaged index considered representative of the US stock market.

 The Economic Policy Uncertainty Index is compiled from three underlying components that quantify newspaper coverage of policy-related economic uncertainty, reflect the number of federal tax code provisions set to expire in future years, and use disagreement among economic forecasters as a proxy for uncertainty.

 The United States Tariff Act of 1930, commonly called the Smoot-Hawley Tariff Act, raised US import duties on foreign agricultural products and manufactured goods. It was sponsored by Sen. Reed Owen Smoot and Rep. Willis Chatman Hawley.

Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.

The opinions referenced above are those of the author as of Aug. 19, 2019. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.