If an investment manager is positioning their portfolio with the view that a recession is on its way, you would expect them to have a compelling model to support such a view.
Among our investigations of strong leading indicators for a US recession, few come close to the reliability and accuracy of the Conference Board Leading Economic Index (LEI).
This basket of indicators has been designed to signal peaks and troughs in the business cycle for major economies around the world, though most prominently this indicator is used for the US.
Today we will summarise the latest release of the LEI, discuss how that aligns with our own view and any implications for portfolio construction.
Firstly, how reliable is this indicator?
Our quantitative testing shows that past a certain point (of which we are past), the LEI has a 90% positive forecast rate – with only a 15% chance of a false positive.
Compare that to most other indicators having a 50/50 rate, and you can take a lot of confidence in the merit of these forecasts.
As a comparison, we maintain a panel of ten leading indicators to help inform our economic cycle forecasting, and the Conference Board LEI is consistently one of the most robust and reliable metrics at our disposal.
What is the indicator saying?
The LEI for the US was updated Saturday morning our time, and the findings are certainly bearish.
Including October’s 0.8% decrease, the index has been falling for eight consecutive months.
This well and truly provides a recession signal for the United States (officially a signal came a few months ago), forecasting that an official recession is likely to officially begin at the end of 2022 and continue through most of 2023.
The release pointed to a deflating consumer outlook, as persistent CPI and rising rates start to put pressure on household balance sheets, and the outlook for residential construction and manufacturing turns increasingly grim.
Looking a little deeper into what is driving this negative outlook, the contributions are negative from nearly all the leading components (see below), suggesting that we’re seeing a structural deterioration in the US economy rather than just a drag on one particular sector.
Given that the LEI tends to lead the business cycle by around 7 months, this suggests that the recession signal earlier this year may materialise in the near future.
This offers a mixed outlook for markets:
- On the one hand, deteriorating economic fundamentals is sure to hurt company earnings, a reality which is not currently priced into forecast earnings for most equity indexes. Bearish
- On the other, a confirmed recession may temper the Fed’s resolve to continue raising rates, giving hope once again to the “Fed pivot” narrative. Bullish
Taking a longer term view as always, we see this as confirmation that there is a higher probability of more pain in equities to come, and consider the reality of deteriorating fundamentals and decreased consumer spending to outweigh the potential for the Fed to pause their rate hiking cycle a few months early.
What about Australia?
On a still negative (albeit not recessionary) note, the LEI for Australia was updated in the early hours of this morning, posting a decline of 0.2%, but has actually risen by 2.4% over six months.
This release paints a picture of our annual growth slowing, but certainly not in negative/recessionary terms – if anything, real GDP appears to be heading back towards the average trend we’ve enjoyed for the past ~20 years.
In contrast to US data, the most recent monthly decline was driven by only one sector (financial components), whilst the six month figures are broadly negative (excluding stocks) – a far more compelling economic landscape.
This aligns with our macro view that Australia is likely to slow but unlikely to enter a recession going into next year, particularly given the recent decisions by the RBA to enact 0.25% hikes in our highly rate sensitive economy.
The economic strength is a double-edged sword for equity markets. On the one hand, this data supports domestic strength and the relative outperformance of the ASX compared to global indexes – however, the valuation profile and our internal forecast models for Aussie large caps is becoming increasingly negative, where other asset classes which have been sold off throughout this year are looking far more attractive in terms of forecast returns.
Look out below
The LEI is a powerful indicator, certainly we value it as part of our forecasting arsenal – and it is not saying pleasant things about the US.
This doesn’t necessarily spell doom and gloom, rather we’d view this as an opportunity to seek out attractive assets now so that should their valuation come down to attractive levels in a slowing economic environment, you can pick up great investments at reasonable prices.
Risk management will always come first, and macro risks like recessions do necessitate you be extremely careful about the sector exposures you take on – however these types of scenarios are the setup which promoted the famous Buffett quote:
“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble”