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Economy Not Over the Hill

Jason Stipp
Robert Johnson, CFA

Jason Stipp: I'm Jason Stipp for Morningstar.

Two types of indicators give us a read on the current and potential upcoming health of the economy. What are they saying now?

Here to offer some insights is Morningstar's director of economic analysis Bob Johnson.

Bob, thanks for joining me.

Bob Johnson: Great to be here.

Stipp: Two types of indicators, coincident indicators and leading indicators. They hope to give us a sense of where we are right now, what's going to happen in the future. Let's start with coincident. What are those indicators and what are they saying about the current health of the U.S. economy?

Johnson: Employment is one of them, income is another, retail sales--what's going out of the stores, and industrial production--what we are producing in our factories. And those are the ones that have historically been considered the key measures of an economy and how it's doing right now. It's not predictive, but it shows where we're at right now.

Stipp: So what are those indicators saying?

Johnson: Those indicators seem to indicate that we are not in a recession at all right now. Every one of those indicators is in an upward trend. The only one that had any fits, if you will, was maybe retail sales. We had a very bad month in May and June and then came back in July. But industrial production continues to move up, and it's near its highest levels of the recovery, as is employment and income. So, we haven't come over the hump, if you will, yet. We're still in an upward trajectory on all of the indicators.

Stipp: Some prominent market-watchers, though, have claimed that we might already be in a recession. If these indicators are very clearly saying that we're not, what are they looking at and how are they reaching those conclusions?

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Johnson: I think some of them didn't see the July retail sales number [yet], and they thought it would just be a matter of time until everything else completely rolled over. And then the data for July on retail sales really surprised everybody on the upside, and August looks like it's going to continue to be at least relatively good--not another decline.

So I think we've broken that string. And there were some thoughts that maybe they'd go back and revise [prior-month] numbers down, and it would look like we were in a recession--because they do revise a lot of government numbers--but I think that maybe that's going to turn out not to be the case this time around.

Stipp: So, good news that it doesn't look like, according to these factors, we're in a recession now, but we still know there's a lot of uncertainty out there. Europe is still in trouble. We're still worried about slowdowns in emerging markets. We've got domestic issues that are going to be coming up soon.

What do the leading indicators say about the potential future health of the economy? Let's start with what they look at first to gauge that future sense of where we're going?

Johnson: Well, there are 10 indicators that go into this. So it's a fairly big set of indicators. But certainly initial unemployment claims, which is one that I have always watched, is in that index, and it is probably the single best leading indicator that's out there.

Then housing permits is another one that's always been a very, very good number, and that's a number that hasn't gotten better until recently, and now we're at three-, four-year highs on that permit number. So that's another thing I have watched very closely. It's in this set of indexes, and is highly positive, so I like that number as well.

And there is a lot of other things in the index--new orders from businesses, new orders for consumer goods are in there, obviously. If you've got orders, that means it's eventually going to be produced and will be picked up in the coincident indicators when we actually make the stuff. But the orders give you some idea, and that's why there are two separate orders metrics in there.

Stipp: So how good have these leading indicators been in the past at predicting what actually came to pass with the economy?

Johnson: Well, you know, they kind of make it a little bit of a moving target. The Conference Board, who constructs this index, periodically says what works, what doesn't, and right now, for example, in the last six months, they have tossed out money supply as a leading indicator, because it's been credit availability and so forth that makes a bigger difference. So they've changed the metric around. So, now they use a survey of bankers to gauge the supply of really lendable funds.

But it's been very good. Any one of the components might be too early, too late, but when you roll them all together, the track record of it has been relatively good and it's been indicated at tops about 13 months in advance of a recession, so almost too much. And on the other side, on the trough, the lead is only two or three months. So, ... you've got to move fast at the bottom. At the top, you got a little time to react.

Stipp: OK. So, what about secular trends in the economy? The economy obviously changes over time. Do you think that the leading indicators are capturing what the economy actually looks like today?

Johnson: You know what, just looking at the raw numbers, it seems like a lot of these are very much manufacturing-related--business orders for this, new orders for that. It seems to be in some of the ISM components that are in the index, it seem to indicate a manufacturing focus.

Now we've got an awful lot of the economy that's in the services economy, and [that] really isn't measured in these indexes. So, I think that's one of the shortfalls of those. And frankly, I haven't got a good answer to that. I wish I knew where to look to find services [leading indicators]. The best projector I can find is if auto sales are really good, services are going to be really bad because people are shopping for cars instead of going to movies or whatever. But it's really hard to find a good way to index services.

Stipp: So it could be that some component of services might be something that they'll need to add in the future, but the way that the index is currently constructed, and it has changed over time, seems to suggest that it has a pretty good track record of indicating where the economy is going to go in the future. And you mentioned that a couple of those indicators look pretty good right now. What overall is the leading indicator index telling us?

Johnson: It is still moving in an upward trend--probably a lesser slope than we've seen in most recovers--but it is still up. For example, over the last six months, I think we're up 1.2%, and we'd like to see something closer to 2% or 3%. We're not there, but it is upward and to the right, so to speak. So that's the good news in terms of the indicator.

May was an up month. June was down fairly substantially--down 0.4%, but then July exactly reversed it with a 0.4% increase. So, we're kind of back to where we were in May. So, again, this whole concept of no-boom, no-bust is what's coming out of this set of indicators as well.

Stipp: So this index will wiggle around a little bit in the short term, but the longer-term trend shows that slow upward slope--no gangbusters--but a slow, steady recovery, probably slower than we'd like.

Johnson: Right, and what you really want to watch for is when that thing peaks out, and when it starts moving down, that's when you start the clock for the 13 months. And by the way, in the last recession, it actually gave us 21 months of lead time. I assume building permits was the number that really drove that number crazy early, because that number really started to deteriorate fairly early before were were even in a recession.

Stipp: Bob, let's turn and talk about some of the indicators that you like to watch. So you have some overlap with some of these leading indicators, but you also look at a few different metrics. What do you look at for leading indicators and what are those indicators saying to you?

Johnson: We've talked about the ones that overlap, which is initial claims and permits and the whole housing industry. Housing put us into this recession, and I think housing is going to be the one that brings us out in a big way. And so, I am watching the housing stuff particularly closely--every single little nuance. For example, we had existing home sales, which looked a little better, up 10% year-on-year this morning. So that was some more good news out of housing, and again a shortage at the low end of the market.

So besides some of the housing stuff, the other one I like to look at is, I have mentioned, inflation. Now [the Conference Board] does have a measure in here--it's interest rates--and they typically go hand-in-hand, but I think as I have talked about before, inflation is really the driver of interest rates, not vice versa. And so I really look to that, and right now we're in a very calm zone in terms of inflation, although I am worried about the drought and what that may do to food prices.

The other one that I would add on there, that [the Conference Board] calls it a coincident indicator, but when I look at the weekly shopping center data, I think it gives me a little bit of a lead on what the consumer is doing, and maybe it's a better way to measure confidence, but in any case, I look at that number and that's not in their indexes.

Stipp: So inflation, the first one, you've mentioned that it kills recoveries in the past when it starts to heat up. What's that level where you really get worried, and where are we right now?

Johnson: The magic number is 4% on year-over-year inflation, and right now we're at about 1.6%. So we're well below. We can have a couple of months of pretty bad food inflation, and we'll still be OK.

Stipp: On the consumer front when you look at some of the consumer trends that we had before the last recession and what our recent consumer trend has been, what would that suggest about the leading insights you can get by looking at consumer spending?

Johnson: Well, like I said, I think the best [leading indicator] that actually turned out [in the last recession] was some of the housing data ... I don't know what it might be this time, but I would certainly watch those consumption numbers very closely.

Stipp: All right, Bob. Thanks for the insights on both the coincident and the leading indicators. It sounds like some cautious optimism about the state of the economy going forward as those indictors at least are still pointing upward for now.

Johnson: Absolutely.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.