A composite of leading indices

Following up on yesterday's post, here's a chart of a composite of leading indices for the U.S.:

When the super-index is below zero, there is a high probability that the economy enters a recession within three to six months. The lowest value of the super-index with a false positive signal of recession since 1967 has been -3.3 (in 2002). As of November 2011, the super-index was at -5.7. November was the fourth month in a row with a negative value. All three components of the super-index were negative as of November.(By the way, I’m using the brand new, improved index from the Conference Board, not the old, useless one.)


The December’11 value for the OECD index is not available yet. The other two indices were higher in December than in November, indicating a weaker signal of recession than in November. However, in all likelihood the super-index will still be around -5.

Statistical models like this do not “guarantee” anything. It’s still possible that a recession doesn’t happen.

One of two things may be happening:
1) The model is correctly pointing to a recession.
2) The model is “breaking down”: it is not able to capture the leading business cycle dynamics at present.

In the absence of any arguments supporting #2, and in light of the broad evidence from domestic and international macro data, it is prudent to say that the risk of recession is high.

It is also prudent considering the large divergence of outcomes. If the model is wrong, and no recession occurs, the best we can hope for is a mediocre recovery. This is what the stock market seems to be pricing in at present. If the model is right, and we do have a recession, sales and earnings will fall way short of “consensus expectations,” macro data will surprise on the downside, and risk-aversion will kick in, in which case stock prices are likely to dip. This is definitely not priced in by the market at present.

Construction of the super-index:

1. Calculate the three-month moving average of each of the following indices: the Conference Board’s Leading Economic Indicator (LEI) index, the OECD composite of leading indicators, and the ECRI weekly leading index. (For the latter, I start with the monthly figure, which is itself a monthly average of the weekly values.)

2. Calculate the six-month % change, at an annual rate, of each of the moving averages from step 1.

3. Average the three % changes.

A less-brave, new LEI

The Conference Board updated this month the composition of its Leading Economic Indicators index. The most important change was the substitution of M2 for a proprietary index of credit conditions. Over the last year, especially, it had become embarrassingly evident that M2 was pushing the LEI up, and that this was not justified by economic conditions. M2 accounts for almost a quarter of the index. Now that the Conference Board has replaced M2 with a more appropriate proxy for credit conditions, the LEI is a lot closer to pointing to a near-term recession than it was before.

Source: John Hussman.

It is not yet clear whether the LEI has reached a cyclical peak, or whether it's just taking a breather. (I, of course, think it's the former.) The six-month change of the index, for instance, is now in negative territory. Historically recessions have always been preceded by a negative six-month change of the index, although there have been instances where such negative change has not been followed by a recession. I have taken the three-month moving average of the LEI (LEI-3MA), in order to remove some of the short-term noise, and then calculated the six-month percent change, annualized, of that moving average. These are the true and false positives of this signal:

Aug. 69: True positive. Recession started in Jan. 70. Avg. value in the three months before recession start: -4.2%

Aug. 73: True positive. Recession started in Dec. 73. Avg. value in the three months before recession start: -5.1%

Mar. 79: True positive. Recession started in Feb. 80. Avg. value in the three months before recession start: -8.2%

Mar. 81: True positive. Recession started in Aug. 81. Avg. value in the three months before recession start: -4.3%

May. 89: True positive. Recession started in Aug. 90. Avg. value in the three months before recession start: -1.7%

Mar. 96: False positive. Recession did not occur. (Only one month when signal was present. Value = -0.77%)

Nov. 98: False positive. Recession did not occur. (Three consecutive months when the signal was present. Values: -0.53%, -0.30%, -0.15%)

Sep. 00: True positive. Recession started in Apr. 01. Avg. value in the three months before recession start: -8.9%

Jul. 06: True positive. Recession started in Jan. 08. Avg. value in the three months before recession start: -5.5% (Warning: in this instance, the six-month change of the LEI-3MA was negative between Jul. 2006 and Feb. 2007, then turned positive for five months, till Jul. 07, and dipped again below zero from Aug. 07 on. In those five months, the six-month percent change of the LEI-MA stayed below 1%.)

Nov. 11: ??? The six-month change of the LEI-3MA was -0.64%, and then it December it was -0.14%. The LEI-3MA does not offer strong-enough evidence, yet, of an upcoming recession.

Which EM economies are most likely to be in trouble?

The Economist has constructed a policy room index. It is intended to measure how much monetary and fiscal space economies have to conduct policy. The index has six components: inflation, excess credit (the growth in bank lending minus the growth in nominal GDP), real interest rates, currency movements, current-account balances, and a "fiscal flexibility index." The combine those inputs to produce an overall "wiggle-room index."

This reminds me a lot of another index The Economist put together a few months ago: the overheading index.

I combined the two indices to find which countries are in "most trouble" (i.e. high risk of overheating and little wiggle room). I set the threshold at 70, for both indices. I find that the trouble spots are: Brazil, Argentina, India, Vietnam, and Turkey.

Accelerating, or decelerating? GDP, or GDI?

We have had evidence for quite some time that "GDP(I) growth is better than GDP(E) growth at tracking fluctuations in true output growth." GDP(I) is commonly called Gross Domestic Income, and GDP(E) is Gross Domestic Product. Conceptually, both GDP(I) and GDP(E) measure the exact same thing, using different methodologies. The main reason, I think, why GDP(E) gets all the attention is that it is released one month earlier than GDP(I). It's also possible that a lot of people still don't know why and how GDP(I) is useful.

In 2011:Q3 GDP(I) grew just 0.22%. Perhaps more importantly for the short-term outlook, the q/q growth rate of GDP(I) has been diminishing during 2011: 2.68% in Q1, 0.26% in Q2, 0.22% in Q3. Far from improving, the U.S. economy seems to have been slowing down.

The growth rate of GDP(E), on the other hand, has been increasing: 0.36% in Q1, 1.33% in Q2, 1.81% in Q3. I do not know of any theory of why the path of the two growth rates is diverging. Nonetheless, an implication of the research mentioned above, by economist Jeremy Nalewaik at the Federal Reserve, is that output growth is more likely to have decelerated than to have accelerated through 2011:Q3. The naive approach of averaging the two measures yields the conclusion that output growth accelerated from 0.8% to 1.01% between Q2 and Q3. Still, a growth rate of 1.01% is nothing to be too cheerful about.

How fast is the economy really growing? We may not know till March 2012 (for Q4 the estimate for GDP(I) will probably be released with a three-month lag, rather than the customary two-month lag).

Fitch downgrades Spain

Fitch just downgraded Spain, from AA+ to AA-. Fitch's rating is now one notch below S&P's and Moody's. The outlook for the rating is negative, meaning that on its current path Spain would be downgraded again in the short to medium term (this interpretation of "negative outlook" is mine, not Fitch's).

(If you don't have an account at Fitch's website, you can read the press release below, which I pasted from the Wall Street Journal.)

Highlights from Fitch's report:

1) Two factors triggered the downgrade: intensification of the euro crisis, and the budget outlook for Spain's regions.

2) "A credible and comprehensive solution to the crisis is politically and technically complex and will take to put in place and to earn the trust of investors."

3) Spain is too large to fail, and will eventually be bailed out if necessary: "Spain’s ‘AA-’ rating incorporates Fitch’s judgement that as a solvent and systemically important sovereign, in extremis, the ECB and/or EFSF/IMF will provide support to prevent a self-fulfilling liquidity crisis."

4) The negative outlook reflects, among other things, contingent liabilities from the financial sector. 

The point that concerns me most is the fourth one. Spain has already spent about 17-18bn. euros in 2011 rescuing (or rather, nationalizing) financial institutions. Two more entities are expected to be nationalized within months. Fitch expects the additional cost of shoring up Spain's banks to be 30bn. euros. Other observers put the bill at 40-100bn, i.e. 4%-10% of Spain's GDP. 


Fitch's press release:

Fitch Ratings has downgraded Spain’s Long-term foreign and local currency Issuer Default Ratings (IDRs) to ‘AA-’ from ’AA+’. The rating Outlook is Negative. Fitch has simultaneously affirmed Spain’s Short-term rating at ‘F1+’ and the Country Ceiling at ‘AAA’.

The downgrade primarily reflects two factors: the intensification of the euro area crisis and secondly, risks to the fiscal consolidation effort arising from the budgetary performance of some regions and downward revision by Fitch of Spain’s medium-term growth prospects.

As Fitch has previously cautioned, a credible and comprehensive solution to the crisis is politically and technically complex and will take time to put in place and to earn the trust of investors. In the meantime, the crisis has adversely impacted financial stability and growth prospects across the region.

However, the still sizeable structural budget deficit, high level of net (although not gross) external debt and the fragility of the economic recovery as the process of deleveraging and rebalancing continues render Spain especially vulnerable to such an external shock.
While gross external debt (169% of GDP in 2010) is not high by euro area comparison, the net external debt of the economy (91% of GDP in 2010) is one of the highest in the world, reflecting a relative lack of Spanish foreign financial assets. This leaves the Spanish external finances sensitive to interest rate increases. While the current account adjustment has been significant, falling from 10% of GDP in 2007 to 4.5% of GDP in 2010 and a forecast 3.2% in 2011, further adjustment over the medium is necessary to improve the external balance sheet.

The intensification of the euro area crisis was identified as a negative rating trigger on 4 March 2011 when Spain’s rating Outlook was revised to Negative. With large fiscal and external financing needs, heightened volatility has adversely impacted market financing conditions for Spain as illustrated by the Eurosystem’s intervention in the secondary market. However, Spain’s ‘AA-’ rating incorporates Fitch’s judgement that as a solvent and systemically important sovereign, in extremis, the ECB and/or EFSF/IMF will provide support to prevent a self-fulfilling liquidity crisis.

The second principal driver of the downgrade of Spain’s sovereign ratings is the budgetary performance of some regional governments, which in Fitch’s opinion, poses a risk to fiscal consolidation. In September 2011, the agency downgraded five autonomous communities and maintains a Negative Outlook on the sector reflecting the still difficult fiscal and economic environment and the execution risks in implementing some of the cost cutting measures announced.

While the sub-national sector’s debt was only 11.1% of GDP in 2010, it accounts for roughly one-third of total expenditure, making it a vital part of the necessary correction in the public finances to restore confidence and public debt sustainability.

The process of rebalancing the Spanish economy is well underway but is not yet complete and Fitch expects it to weigh more heavily on economic growth over the medium term. The agency projects annual economic growth to remain below 2% through to 2015 and unemployment to remain high. Despite the important measures already adopted by the government, further structural reform will be necessary to further enhance the competitiveness and productivity of the economy. The fundamental weakness of the labour market, as underscored by an unemployment rate in excess of 20%, is a material rating weakness relative to European and high-grade peers. Nonetheless, while the recovery over the medium term will be lacklustre, Fitch expects the long-term (ie, post-2015) potential growth rate to exceed the average for the euro area as a whole.

Despite the weakened risk profile, Fitch views Spanish sovereign solvency as secure. Under the agency’s baseline scenario, the debt to GDP ratio will peak at 72% of GDP in 2013, well below the forecast euro area average of 89% in 2013.

Spain’s ‘AA-’ rating reflects strong fundamentals: a diversified, high-value-added economy and strong governance. The government’s policy response has been credible and aggressive.
The Negative Outlook reflects the risks associated with a further intensification of the euro area financial crisis, as well as possible material fiscal slippage and to a lesser extent contingent liabilities from the financial sector. A material deviation from the government’s fiscal targets and failure to stabilise the government debt to GDP ratio from 2013 would place negative pressure on the rating. Substantial progress has been made in the restructuring of the banking sector and Fitch has not revised its estimate of the ultimate fiscal cost which is moderate and is consistent with the current rating.

The amount disbursed by the Fund for Orderly Bank Restructuring (FROB) is estimated at EUR17.3bn by end-2011. Under Fitch’s baseline scenario, Fitch assumes that a further EUR30bn (2.8% of GDP) of capital is required from 2012 based on the agency’s stress-test exercise. This is to cover additional losses while maintaining a strong core capital ratio of 10% for the system. Fitch views the costs as manageable. Should recapitalisation costs be significantly higher than this figure, the rating could move into the ‘A’-range.

On a wide range of economic and fiscal indicators Spain has underlying fundamentals consistent with maintaining its sovereign rating in the ‘AA’ category. Success in meeting its fiscal targets and progress on structural reform that would further enhance competitiveness and growth prospects would stabilise the rating, as would resolution of the euro area crisis.