Leading Indicators and Post-Rate Cut Performance

The International Monetary Fund just released their quarterly update to the World Economic Outlook, and now projects real global economic growth to slow to 3.2% this year (from 3.6% in 2018 and 3.8% in 2017). Interestingly, the main downgrades in growth were concentrated in emerging market economies, including India, Russia, Mexico and Brazil.

Developed economies weren’t heavily affected, with Europe’s outlook remaining unchanged and the U.S slowdown now expected to be more benign than previously forecast. One thing that should be noted, however, is that economic growth for advanced economies is projected to come in at 1.9%. The 3.2% rate mentioned above includes a boost from developing economies, which are expected to grow at a 4.1% rate.

This forecast for modest growth in the back half of the year is supported by recent changes in The Conference Board’s Leading Economic Index, pictured below. Released last Thursday, the U.S. LEI fell 0.3% in June, following no change in May and a 0.1% increase in April.

The Conference Board's Leading Economic Index

This is the first decline since last December (when the stock market swooned) and points to sluggish growth moving forward. According to The Conference Board, it was weakness in new orders for manufacturing, housing permits and claims for unemployment insurance that took the index lower.

Since we’re on the topic of leading indicators, let’s take a quick look at the most recent changes in LEIs for our trading partners. In the table below, we can see that the majority of countries are also seeing their outlooks worsen, with a few exceptions.

Leading Economic Indicators by Country

But there are some signs of life out there. If we switch gears for a moment and look at OECD data, we get the feeling that a turn could be in the offing. First, here is the OECD’s Composite Leading Indicator (CLI) for the OECD economies as a group.

OECD Total Composite Leading Indicator

While the CLI is still declining, it’s rate of change is beginning to slow. The OECD refers to this as “stabilizing growth momentum” which is an improvement from last month’s “easing growth momentum.”

What’s more, if we include nonmember countries (chart below), it appears that a firmer bottom is coming into view.

OECD + Nonmember Countries CLI

This is being driven in part by China, which as you can see below, appears to have made a turn for the better – at least according to the data that the OECD is looking at. Could all the recent stimulus China has been enacting finally be paying off?

OECD China CLI

Finally, a quick look at the CLI for the United States provides two important takeaways. The first is that the downward momentum in the CLI (blue line) is beginning to slow. This could signal a possible bottoming in the months ahead if conditions continue to improve.

OECD U.S. CLI

While that’s a potentially good sign, the other takeaway is that the reference series (red dashed line), which is a measure of economic activity, has not yet rolled over as it typically does following a move lower in the CLI.

This means that a deceleration in U.S. growth more than likely still lies ahead. Even if the U.S. CLI does bottom out and head higher in the coming months, we may still have to endure a period of moderating growth in the near-term. The message here is therefore quite similar to the one coming from The Conference Board’s LEI – expect soft growth for the back half of the year.

The moderating global growth outlook that can be seen in the charts above has led us back into a period of aggressive monetary easing. Aside from the Fed, which is poised to cut rates next week, the European Central Bank has sent a clear signal it intends to reduce rates and resume asset purchases.

In addition, many central banks in the Asia-Pacific region have already lowered rates this year, including Australia, New Zealand, India, Malaysia and the Philippines. South Africa, Korea and Indonesia cut rates just last week.

So it’s evident that central banks around the world are now in a coordinated easing program, and this should help to bolster growth moving forward.

Moving on, one of the most important questions being asked right now is where to invest when the Fed starts cutting rates. The WSJ recently put together a great infographic on this, which is displayed below. It shows returns across stocks, bonds and gold following rate cuts in 1995, 1998, 2001 and 2007.

Performance Since Initial Fed Rate Cut

In order to appreciate this chart, we need to recognize that the cuts in 1995 and 1998 were NOT followed by a recession, while the cuts in 2001 and 2007 were followed by a recession. With that in mind, here are a few important takeaways:

First, in the initial few months following the Fed’s first rate cut, there is not a whole lot of movement in any of the major asset classes. This is most likely a reflection of investors trying to get a handle on the underlying direction of the economy, before they make big bets one way or the other. It’s only about three months after the initial rate cut that we begin to see some performance separation.

Second, and rather obviously, the performance of stocks and gold is heavily dependent on whether the economy ultimately heads into a recession or not. If the Fed is successful in staving off a downturn, stocks rally strongly in subsequent years, but if not, they fall precipitously. The same is true of gold, except in reverse. Gold rose sharply during the 2001 and 2007 recessions, but fared poorly in 1995 and 1998 when economic growth rebounded.

The third interesting takeaway is that in all four scenarios, bonds held up just fine. They performed a bit stronger when the economy was followed by recession (as one would expect), but since inflation has been subdued for many years and there is a ton of cash sloshing around the economy searching for yield, interest rates no longer have a habit of rising when the economy grows.

Bonds, therefore, appear to be a relatively safe bet regardless of where the economy heads … the only problem is that with today’s low yields, bonds barely pay enough to maintain purchasing power.

Taking all of this into consideration, it seems to me that the longer-term outlook for stocks remains fine, as there are no imminent signs of recession and we already have a lot of stimulus moving through the system in the form of lower rates.

That said, I think most of the upside in the near-term has been priced in and we could see the market tread water for a little while, or perhaps correct a bit. The recent rally that we’ve seen over the last two months (since Mr. Powell’s pivot) has taken the forward P/E ratio for the S&P 500 to 17.0 (Factset), which is above both the 5-year average (16.5) and the 10-year average (14.8).

Speaking of the S&P 500, here is a daily chart just to bring you up to speed on the latest price action. After hitting new highs last week, the market is digesting those gains and remains above support.

S&P 500 Index

As for gold, it too is holding strong above its primary support level.

Spot Gold Price

If things play out in similar fashion to how they did during the last four rate cut cycles, the relative performance between these two asset classes over the next few months could give us an indication of how the economy will fare. So stay tuned!



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