In one way or another, economic indicators provide some insight into the future direction of the economy. The experience of past economic downturns tells us that this interest is, in and of itself, a sign that some progress has been made at moving through the economic downturn and that we’re getting closer to better and more normal times.
But how useful are leading indicators, and what ones should we look at? I find no magic economic or financial market indicator, and especially no single indicator that works every time. It is best to pay attention to a few indicators and exercise some judgment in interpreting them. The value of a leading indicator is often in the eye of the beholder. If it were otherwise, why would market analysts and economists use so many different indicators to forecast the future?
One useful economic indicator is readily available from Statistics Canada and is aptly called “Leading Indicators.” It is published on a monthly basis (usually the third week of the month) and consists of 10 component indexes and an overall composite index, which is made up of an unweighted aggregation of the components. Individually, each component has some predictive power.
1. Housing refers to a composite of housing starts and sales of existing houses. In “normal” recessions and recoveries, the beginning of the recession would see high interest rates and an accompanying drop-off in housing activity. As interest rates dropped during the recession, they would stimulate this very interest-rate-sensitive sector. This time around, housing fell off sharply in the United States largely because of a great deal of imprudent lending — loans that couldn’t be repaid — and in Canada because the housing boom had simply run its course. Therefore, what we are looking for this time are housing prices to stabilize and the return to a modest increase in housing starts, sales and prices.
2. Business and personal services employment is useful because the service industries are labour-intensive. In other words, any substantial increase in demand for services is likely to require an increase in employment. In contrast, more capital-intensive industries, such as mining or manufacturing, are generally able to ramp up production before hiring additional workers.
3. S&P/TSX stock price index is included because markets, especially equity markets are forward looking. The S&P/TSX index has demonstrated its capability of forecasting economic recoveries in the recessions of the early 1980s and early 1990s. This isn’t an infallible guide, but it is certainly worth including in anyone’s list of leading indicators. This index is probably the one that garners the most amount of attention and news coverage on a daily basis.
4. Money supply M1 is a fairly narrow measure of money supply (a rough definition would include currency outside banks plus all chequable and non-chequable deposits held at chartered banks, trust and mortgage loan companies, credit unions and caisses populaires). The rationale for including it among the leading indicators is that a (rapidly) rising M1 indicates that the central bank is pursuing an expansionary monetary policy, which, for example, makes it easier for people to borrow and spend by ensuring that there is plenty of money in the system. Currently, the Bank of Canada is in an expansionary mode.
5. U.S. Conference Board leading indicator. What goes on in the U.S. economy and financial markets has an important bearing on similar activities in Canada. The two economies don’t always operate in lockstep, and there are huge differences in the state of financial institutions at present (in Canada’s favour), but any Canadian leading indicator worth its salt needs to include something from the United States.
6. Average workweek in manufacturing. The usefulness of this indicator relates to what was said earlier about business and personal services employment. In a capital-intensive sector such as manufacturing, production can be increased a lot through simply running more of the machinery or running it faster. Initially, at least, only a little additional input is required from workers, and this can be achieved by extending the workweek of current employees before it is necessary to begin hiring.
7. New orders, or durables, include items such as industrial equipment, aircraft and motor vehicles. Nearly all durable goods share a couple of basic characteristics: they command a high price, and you can’t buy a fraction of a durable good. In practical terms, this means that if a firm does order a durable good, it is because the firm expects to be able to utilize most, if not all, its capacity. That expectation is a good indicator of increasing economic activity in the future.
8. Shipments / inventories of finished goods. Rising shipments of finished goods are a pretty good indicator that demand is picking up. Inventory changes, however, require a little more interpretation. When an economy slows down, some firms are slow to recognize that they must reduce their production. When that happens, inventories build up. Therefore, as part of the adjustment process, we look for a decline in inventories. After that happens, any increase in demand will be translated directly into an increase in production and shipments. The basic sign of health of this indicator is the ratio of shipments to inventories. A decline in the ratio, or even a period of little change, indicates that further increases in demand will translate into additional production.
9. Furniture and appliance sales are referred to as consumer durable goods and are similar to industrial durable goods in that they are higher priced than many day-to-day purchases that consumers make and one typically doesn’t purchase half a washing machine. Increased purchases of these goods indicate an increased level of confidence on the part of consumers regarding their economic prospects. A pickup in furniture and appliance sales may also be an indication of rising housing activity.
10. Other durable goods sales include virtually all consumer durable goods sales — such as motor vehicle sales — except the furniture and appliance sales included in furniture and appliance sales. As noted above, increased sales of consumer durables indicate an improvement in both consumer finances and in confidence about the future, especially with respect to expectations about steady employment and personal incomes.
The best use of the composite index is to consider both the headline figure as well as the component measures when they’re released each month (you can keep an eye out for the next report by signing up for Statistics Canada’s daily e-mail on what will be released the following day). Remember, this is not a tool that predicts the health of the economy two or three years from now. Rather, it is a good and consistent way of keeping an eye on the economy’s near-term prospects. The leading indicator was negative in the most recent release. It fell 1.3% in March, following a 1.4% drop in February. While this represents an improvement month over month, it’s still in negative territory.
There are many other things that analysts and economists consider, but most advisors don’t have the time to make this a full- or even part-time occupation. The financial press is one of the leading indicators that virtually everyone looks at. Like the specific indicators, some interpretation is in order. You may have noticed a swing in press sentiment in recent weeks. My interpretation is that it has gone from far too pessimistic a few months ago to probably a little too optimistic at present. There is no question it is good news that things are getting worse more slowly. However, that is not the same as things improving, which will follow.
Finally, even though we are all focused on near-term improvements, we also need to think longer term. When we do get out of the current recession, we can look forward to a period of economic growth and, hopefully, markets that anticipate and reflect this. We also know that at some point in the future, there will be another market or economic downturn. The past couple of years, difficult as they have been, have taught — or reminded — us that the future is uncertain. We don’t need leading economic indicators to tell us that, and we would be smart to prepare for it.
Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in examining retirement in Canada today.
(05/12/09)