Economic indicators are used by investors to calculate the future condition of the economy but which ones are the most useful?
For anyone seeking broad indicators as to the future direction of equity markets, there is certainly no lack of economic information available from expert organisations around the world.
At the end of July for example, global research network The Conference Board announced that the US leading index, an amalgamation of leading economic indicators, increased 0.3% in June ' which analysts took to be the result of persistent rate cutting by the Federal Reserve.
In the UK meanwhile, analysts were waiting for the Office of National Statistics to produce preliminary estimates for economic growth in the second quarter, an official indication of how well the UK is withstanding the global economic slowdown.
Despite rumours circulating the financial services industry that annual growth might have slowed to 1.8%, the actual figures revealed 2.1% growth. Over the second quarter, the economy had expanded 0.3%, down from 0.5% in the previous quarter and the lowest rate since December 1998.
Analysts took this lower growth rate to indicate economic weakness in the US and Europe was filtering into the UK, and as further evidence of the two-tier economy operating in the UK, with strong growth in consumer spending while the manufacturing sector teeters on the edge of recession.
But although most investment houses run their portfolios in line with some sort of macroeconomic framework, just how useful are economic indicators in helping to determine the future direction of equity markets?
Head of insured funds at Aegon Asset Management, Tom Copland, says that while he does pay close attention to leading indicators, the future direction of the economy and of equity markets are two different things.
He says: 'Data from leading economic indicators tends to focus on the demand and output side of the economy and tells investors very little about competitive pressure in industries, for example, or what has already been priced into equity markets. Looking at economic indicators in isolation and not applying the information at stock level will provide few practical signs as to how equity markets will develop.'
Of the three main categories of economic indicator available ' leading, lagging and coincident ' leading indicators are obviously the most closely watched by investors as they can be used to predict the future condition of the economy. Calculated to highlight the peaks and troughs in business cycles, the UK leading economic indicator has eight separate components: money supply, export order book volume, inverted bond yields, stock prices, changes in consumer confidence, new orders in the engineering industry, changes in inventories and housing statistics.
As defined by Bloomberg Financial, a coincident indicator is an economic gauge that follows an industry sector or the economy in general and a lagging indicator is an economic measure used to determine, after the fact, the financial condition and stability of an industry or economy.
Market economist at Gartmore, Jamie Lewin, believes the practical importance of leading economic indicator data depends on the current stage of the economic cycle. If there is fear of recession, then industrial production is important for example. If the threat of inflation were lurking, people would tend to look at indicators like money supply and average earnings.
'Rather than focusing on a predetermined set of leading indicators, we tend to look at whatever information can help provide a barometer of the present health of the economy,' he says. 'Having identified the relevant leading indicators, we then look at how much the information is currently reflected in share prices ' if GDP is turning up for example, does this have positive implications that are not yet priced into the market? This can often highlight buying opportunities as it shows where the outlook for earnings is generally underestimated.'
With global economies becoming increasingly synchronised and developments in larger countries dictating general economic direction, economist at Royal & SunAlliance Investments, Steven Andrew, pays most attention to leading indicators from the world's leading economy ' namely the US.
He believes the most important indicator for future equity market direction is almost certainly the monthly reports from the National Association of Purchasing Management (NAPM), which give a good reflection of state of the industrial cycle and show when external demand for goods will pick up.
Of the two reports the NAPM produces every month ' manufacturing and non-manufacturing ' the former receives the most attention because of its long track record of marking turns in business activity. Although the UK has a similar body of its own in the form of the Confederation of British Industry (CBI), Andrew feels the CBI's transatlantic cousin is a more important indicator for UK markets.
'While CBI surveys are an important source of information,' he says, 'they do not have the power to turn markets and we tend to use them to underscore our existing economic arguments that are usually based on what the NAPM is saying.'
Chief economist at Gerrard, Mike Lenhoff, is another investor who feels more confident looking towards US leading indicators for insight into the UK. While he believes many CBI surveys are closely correlated with economic shifts, he does not find them to be a particularly useful starting point to determine future equity market direction.
'For me, the most important information comes from the US purchasing manager surveys,' he says. 'If you have Datastream software, it is possible to see the various individual components of these surveys ' new export orders, sales ratios and unemployment, for example ' which allows you to trace the business sequence, the chain of causality, that will determine shifts in economic activity.
'If you think about it, stock levels will dictate the level of production: if stocks are depleted, orders will go out to replenish them. This means the new orders index is closely correlated with industrial production and therefore with future upturns in economic activity.'
Copland says he prefers this type of survey data to more 'official' indicators such as inflation or GDP growth, as business confidence-type information gives the first clues as to when the economy is starting to turn up. 'With official Office of National Statistics data on something like quarterly GDP growth for example, the information is released months after the actual events and has often been revised,' he says.
Although most analysts consider consumer confidence surveys to be a good indicator of general economic health, few see them as having any further influence on equity market direction.
'Consumer confidence is a good reliable indicator of potential economic growth,' says Copland, 'but if employment is growing and wages are strong, it's a fair bet that confidence will be high. Even with the uncertainty in the UK economy this year, consumer confidence has remained steady in line with the relatively healthy employment picture.'
Andrew has much the same view about the predictive value of consumer confidence, although he does believe it would become a more important indicator were it to fall suddenly ' as this would signal a more serious slowdown than most people expect.
'Consumer confidence is less important new than it was at the start of the year when we faced the possibility of global economic slowdown and had Greenspan talking about breeches in the fabric of consumer spending,' he says. 'Such a breech has obviously not occurred and confidence has tended to move in line with employment growth.' One further indicator that many investors use to determine the future for equity markets is the slope of the yield curve and the distance between yields at the short and long end of the curve. The slope of the curve basically suggests whether prevailing monetary policy is loose or tight ' at present in the US, for example, short yields are at 3.75%, mirroring real interest rates after aggressive cutting by the Federal reserve this year, while long bond yields are at 5.5%.
According to Copland, very low yields at the short end suggests loose monetary policy and therefore a weak economy in all probability, and the slope of the curve suggests how much confidence the market has in an economic recovery.
Andrew says that the most important element of an economic indicator for him is whether or not it can provide a link between economic issues and earnings.
'At the moment,' he says, 'there is a certain sense of dislocation in the UK market, with the relative macroeconomic optimism over an expected upswing in the fourth quarter offset by a series of earnings disappointments in the second quarter. The main trick of using economic indicators is to find information that provides this missing link between deteriorating earnings and improving economy.'
As a final note of caution, Copland sounds a warning about following leading economic indicators blindly. 'In 1998, the business confidence figures were showing perhaps the lowest readings ever, implying a subsequent recession, and 1999 turned out to be a good year in economic and market terms,' he says.
'It's not out of the question that some of the companies responding to these surveys are game playing to a certain extent ' perhaps they think that if they say things are awful, the Monetary Policy Committee might come to the rescue with a helpful interest rate cut.'
• In isolation, indicators will provide few clues as to equity market direction.
• Consumer confidence would be a more important indicator if it were to turn down suddenly.
• Indicators can provide the link between earnings and the economy.
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