After a 2017 upturn, slowing GDP growth and dipping monthly data like purchasing managers’ indexes (PMIs) had many expecting weakness in eurozone stocks in 2018. And, when eurozone stocks started slumping—trailing US markets—many blamed these weaker data. Now, though, with US markets suffering an awful Q4—especially most of December—folks have switched gears, worrying markets foretell economic weakness ahead. Yet in our view, observers can’t have it both ways—and even the correct view is more nuanced than many observers allow for. Markets are a leading indicator, seemingly justifying the recent view, but they are far from perfect. Investors must approach both theories—that economic data foretell stocks and the notion stocks’ swings accurately predict the economy—with caution.
To begin with economic data, the most common stat folks hinge their view on is Gross Domestic Product, or GDP. GDP is a government-produced estimate of national economic output. It measures spending, investment and trade in an attempt to give a snapshot of how the broad economy is faring. Though widely tracked and cited, GDP’s limitations mitigate its usefulness for investors. Its biggest shortcoming for stock investors: It is backward-looking, like most economic data. The BEA releases its initial GDP estimate about a month after the quarter’s end. So at best, the report tells you which segments of the economy grew and contracted one to four months ago. However, forward-looking stocks don’t care what the economy just did. We believe stocks are effective (if imperfect) discounters of all widely known information, so for them, GDP data are old, long priced-in news. Stocks already moved on.
Besides this innate limitation, GDP is a blunt instrument with several calculation quirks. The broad econometric tracks both the private and public sectors. Yet stocks represent only publicly traded firms—primarily the private sector’s domain. Moreover, what GDP considers as positive and negative doesn’t always align with what is positive and negative for businesses. For example, imports detract from headline GDP. However, imports also represent domestic demand. If imports slipped, it could signal companies are facing headwinds and are cutting back—but GDP would register this as a positive. Conversely, a firm that sells a lot of imported goods may see rising imports as a positive.
Similarly, GDP treats rising inventories as positive. Yet to a firm, rising inventories could be good (stocking up ahead of expected demand) or bad (inability to move product). GDP also treats all government spending positively, regardless of how efficient that spending may be. We are ambivalent about government spending—it makes sense under certain circumstances, like during the throes of a recession. However, we also don’t see more public spending as innately good, since it could be poorly spent or potentially crowd out private business.
As for the notion markets predict weakness, we agree in principle. But they aren’t perfect at it. Economist Paul Samuelson once quipped that stock markets have predicted nine of the last five recessions. He has a point: Volatility in markets often far exceeds—and has no relationship to—economic trends. Selloffs of -10% to -20%, often called corrections, happen regularly during bull markets and economic expansions. They are sentiment-driven, fueled by fears—not reality. In addition, some bear markets have no associated recession. 1962, 1966 and 1987 exemplify this. These bears tend to be shallow and short, almost rendering their description as a bear questionable. In our view, if you are trying to assess whether a bear with a recession looms—typically far more damaging—forward-looking economic indicators should comport with markets’ signals. Today, they don’t.
For example, The Conference Board’s Leading Economic Index (LEI) for the US remains in an uptrend today. In LEI’s almost 60-year history, no US recession has begun when it is rising like it is now. Also, the 10-year minus 3-month US Treasury yield spread—the difference between long and short interest rates and a LEI component—remains positive.[i] The yield spread is a proxy for loan profitability. Banks borrow short term to fund long-term loans. Hence, they will typically lend—providing fuel for growth—as long as they have the proper incentive (i.e., profitability on the loan). A positive yield spread suggests that incentive is intact today. The New Orders components of PMI business surveys have long been in expansionary territory.[ii] Considering today’s orders are tomorrow’s production, this points to future growth, too. In our view, no single dataset is all-telling, and all can be volatile in the short term. However, taken in tandem, forward-looking data suggest more economic growth is likely—and recent volatility in markets is either a deep correction or a recessionless bear, which is a distinction that lacks a lot of significance, in our view.
Forecasting markets and the economy requires more than surface-level analysis incorporating one input, whether it is an economic data point or market movement. Hence, we suggest diversifying your view of forward-looking data to get more clarity on where markets—and the economy—are headed.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] Source: Federal Reserve Bank of St. Louis, as of 12/28/2018. 10-Year Constant Maturity Minus 3-Month Treasury Constant Maturity, 12/31/2013 – 12/26/2018.
[ii]Source: FactSet, as of 12/28/2018. New Orders Indexes for ISM’s Manufacturing and Non-Manufacturing PMIs, 12/31/2008 – 11/30/2018.
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