To equip investors with a sense of how the economy is faring, US government agencies and other organisations release regular data measuring indicators such as gross domestic product, unemployment and inflation. While this data can be beneficial to understanding the health of the US economy and potential investment trends, not all of it is useful for gauging stock market trends.
While sudden changes in economic conditions can lead to short-term stock market reactions, the effect of any single piece of economic data on share price will eventually fade over time, providing little insight into the future direction of the market.
That said, not all indicators are born equal. Here are two of the most significant, but lesser-known economic indicators, that can help individual investors think strategically about shifting market conditions and investing in US markets.
1. Yield Curve
As far as indicators go, the yield curve is an important one. Historically the inversion of the yield curve has been a good indicator of an impending recession.
On its face, the yield curve is a snapshot of the yields, or expected rates of return, on a collection of bonds of different maturities, from the very short to the very long. The “curve” is the line one could plot connecting those yields, and its shape can tell investors a significant amount about market perceptions of the economy.
What’s in the curve?
The shape of the curve can change as yields fluctuate in response to shifting economic conditions. In general, the short end of the curve is dictated more by the Federal Reserve’s interest rate decisions, while the longer end of the curve reflects investors’ expectations about the future course of inflation and economic growth.
If the economy is growing strongly, the yield curve tends to steepen as investors grow concerned about inflation and potential interest rate hikes by the Fed. As a result, they might start to avoid longer-term bonds, causing their prices to fall and their yields to rise.
When the Fed raises interest rates, the yield curve tends to flatten as short-term yields rise and inflation expectations ease.
However, if the Fed raises rates too quickly, causing short-term yields to rise above long-term yields, then the yield curve can invert. It’s at that point when investors start worrying about a potential recession, as high rates slam the brakes on growth and inflation expectations.
The yield curve: 50 years of accurately forecasting recessions
MSCI World Index inception at start of 1970.
Source: Charles Schwab, Bloomberg data as of 6/7/2017.
Why does an inverted yield curve signal a major peak for the stock market? Every recession in the US — and accompanying global economic recession over the past 50 years — was preceded by an inverted yield curve. The yield curve inversion usually takes place around 12 months before the start of the recession, but the lead time ranges anywhere between five to 16 months. The peak in the stock market comes around the time of the yield curve inversion, ahead of a recession and accompanying downturn in corporate profits.
One reason why an inverted yield curve can be a signal of a recession is that the difference between short- and long-term rates is a proxy for bank lending profitability. Banks tend to borrow at short-term rates and lend at longer-term rates, earning the yield spread. So, when the yield curve inverts or collapses – it becomes less profitable for banks to lend, slowing down economic activity.
2. Leading Economic Index (LEI)
Investors often focus on traditional measures for the economy, like the GDP, as a sign of how the economy is doing, but it’s important to remember that GDP is a lagging economic indicator.
How so?
GDP reports what has already happened in the economy – and not what’s about to happen. This is why economist market watchers spend more time focusing on the leading indicators, such as the Leading Economic Index (LEI) put out by the conference board. This index offers a monthly look at 10 subcomponents (including the S&P 500, and the yield spread between ) – all of which tend to lead changes in the economy. While the index’s individual components might not mean much on their own, there are times when they all start moving in tandem and markets can sometimes follow.
This index was created to pick up major inflection points in the economy and provide a heads-up when there is elevated risk of a recession, as well as an indication when the economy is coming out of a recession.
The table below takes a broad look at what is covered by the LEI and what it might mean for the economy.
Planning and rebalancing
Ultimately, any one data point can move markets in the short term, but over the long term data has much less influence. So, while there is little long-term value in basing investment plans on the pace of growth, in some cases signals about the health of the economy can prepare for short-term bouts of volatility.
In addition to watching indicators, investors should aim to remain diversified and disciplined in line with their long-term individual investment goals. All things considered, it’s important to remember that a more challenging investment environment requires a more disciplined and patient approach to investing.
Lachlan McPherson, Senior Investment Consultant, Charles Schwab Australia Pty Limited
Important Disclosure
Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data. (0918-8YHM)
