Some say the worst is behind us. If they were right we would already have seen an upturn in a broad array of reliable leading indicators. This has yet to happen.
Why the confusion?
Confusion about what comes next is normal around cyclical turning points because prognosticators often mix up leading, coincident and lagging indicators in the presentation of various viewpoints. For example, think of the economy as a long train with an engine, coaches in the middle and a caboose. The train begins to round a bend in the track and the engine disappears from view. If you are focused on the coaches and caboose you would not realize that a turn was imminent. However, if you watch the entire train you will see the engine turn and expect the coaches and caboose to round the bend in succession. Using the analogous, leading indicator approach for interpreting developments helps make sense out of otherwise confusing data.
This cyclical approach is based on the fact that that in free market economies like the U.S., leading, coincident and lagging indicators always turn up or down in a durable sequence at cyclical turning points. This allows us to answer the question, when will things turn and go the other way?
Leading vs. coincident indicators
Accordingly, the Economic Cycle Research Institute (ECRI) focuses on relationships that exist when the economy is likely to shift from expansion to contraction or vice versa. ECRI's founder, Geoffrey H. Moore, over thirty years ago, developed the first set of leading economic indicators used by the U.S. government. Today we use a much larger array of leading indexes that provide a highly nuanced view of the cyclical outlook. These indexes allowed us to correctly forecast the last recession, which began in July of 1990, five months in advance.
Leading indexes are designed to turn a few quarters ahead of coincident indexes that describe current economic activity. Coincident indexes include measures like output, income, employment and sales. After February 1990, when we made our last recession call, GDP (a coincident indicator) came in positive for Q1, Q2 and Q3 was initially reported positive only to be revised down later. ECRI maintains about a dozen leading indexes for the U.S. economy including three for the overall economy, five for various sectors of economic growth like services, manufacturing and international trade and separate leading indexes for the employment and inflation cycles.
Reading the leading indexes
Last fall the leading indexes weakened to a point not seen during this expansion, telling us that that the risk of recession was very real. Despite the Federal Reserve's interest rate cuts earlier this year, the leading indexes have turned more pessimistic in recent months. Their clear and collective message is one of contraction ahead for the U.S. economy, making it very unlikely that the economy will avoid a recession this year.
The exception is the Leading Services Index, which has lagged behind other leading indexes on the way down, offering hope that the service sector could help prevent an overall recession. However, the key to service sector growth going forward is stable consumer confidence.
Ominously, growth in the Leading Employment Index has plunged to a 19-year low – worse than in the last recession signaling that the jobless rate will rise significantly in the next few months and undermine consumer confidence. Once confidence starts to plunge afresh, it is unlikely that service sector growth will hold up.
Autos, Housing and Tech
Some will point to strength in the auto and housing sectors as good reasons why a recession is unlikely. Given our understanding of how these indicators perform at cyclical turns, we know that sales are coincident and do not lead the economy at turning points. Both the housing and auto markets have remained fairly healthy because interest rates are falling and unemployment is low. But if unemployment rises as forecast by the Leading Employment Index the cyclical downturn in autos will resume and housing will weaken.
It is hard to suggest, however, that the information technology sector will help ward off recession. The tech share of overall GDP is now 8% compared with a little over 3% for autos, and it remains locked in a global cyclical downturn characterized by near-term excess inventory and longer-term overcapacity.
Point of no return
Meanwhile the pattern of movements in most of the leading indexes continues to deteriorate and the economy has clearly veered onto the recession track. This message is evident from a chart of the Weekly Leading Index (WLI) of the overall economy. The current downturn of the WLI is shown juxtaposed over its previous performance during slowdowns that do not turn into recessions and those that do. In the six months following a peak in economic growth it is difficult to distinguish between slowdown and recession tracks. However, the tracks then diverge and, as the chart shows, we are on the recession track.
Of course, the economy will eventually recover from this recession, but that cyclical upturn is not yet in sight, and may not begin until next year. Furthermore, the U.S. downturn is bad news for Asia, which is heavily dependent on exports to the U.S., and is likely to plunge into renewed recession. The European economies are also slowing as a synchronous global slowdown intensifies. As a result, there is no locomotive anywhere in the world to help pull the U.S. economy out of recession. This global backdrop will tend to prolong and deepen the U.S. recession.
For a decade, recession was kept at bay by a combination of luck and skill. But in market economies, recessions cannot be postponed indefinitely. As imbalances build, they demand the catharsis of a recession, which lays the foundation for the subsequent recovery. Thus, while a recession can bring hard times, it is part and parcel of a free market economy, and integral to its long term growth.
Lakshman Achuthan
Managing Director
Economic Cycle Research Institute (ECRI)
http://www.businesscycle.com
30 April 2001