This Number Predicted Recessions Before – Here’s What It Says Today

When leading stock market indexes post triple-digit-point losses in a day, commentators, like clockwork, unleash a barrage of stats, technical indicators, bearish charts, bullish charts and dead cat bounces to explain it all the best they can. And the recent bout of volatility has made the stock market awfully noisy.

But rather than getting caught up in the commotion, let’s instead slip on a pair of Bose noise-cancellers and listen to a 10-piece orchestra play a symphony about the entire economy. This metaphorical financial opus is known as the Conference Board Leading Economic Index (LEI) – sorry Beethoven fans – and history has shown it’s been one of the more reliable predictors of recession.

Published monthly, the LEI is a calculation that combines 10 leading measures of economic activity, such as the S&P 500, consumer confidence, building permits, unemployment levels and more, into a single number that serves as a barometric reading on the economy.

It’s a number that Northwestern Mutual Chief Investment Strategist Brent Schutte has kept a close eye on this year, and despite recent choppiness in the market, it’s given him reason to remain optimistic about the broader economy. Here’s why.

TANKER SHIP ECONOMY

Although calculating the LEI is complex, understanding its usefulness isn’t: The LEI typically dips before a recession and begins moving upward before an expansion. A downturn in the LEI, for example, can presage a recession by anywhere from a few months to a few years, and vice versa for a looming expansion. And for the past 50 years or so, this up and down movement of the LEI has predicted the economy’s direction. In October, the LEI jumped 0.1 percent to 112.1, the 13^th straight month of LEI gains. Over the past year, LEI has been up 5.9 percent, a strong indication to Schutte that more economic growth is coming.

“Prior to each of the past seven recessions, LEI was at 0 percent or even negative year-over-year,” says Schutte.

He believes this is a very encouraging sign, despite what you’ve seen in the market recently. If you look at any of the LEI components individually, say, the S&P 500, you might see wild swings from month to month. But when you compile all 10 components together, you smooth out short-term gyrations and get a more holistic picture of what all economy’s moving parts are saying. Getting this perspective is important because the economy moves with the grace of a tanker ship – it takes a lot of time to turn or slow down, and once this massive ship is moving in a certain direction it tends to do so for quite some time.

The markets, on the other hand, dart around like jet skis. A mere whiff of bad news can shift sentiment and send stocks free-falling in a single day. And throughout 2018, there have been plenty of foul smells floating around the market with international trade tensions and concerns about future policy actions from the Federal Reserve. Investors are worried tariffs and the potential for retaliatory policies could derail growth, or the Fed could raise interest rates too quickly and kick-start a recession. Those worries have carried over to markets and sparked a handful of selloffs in 2018.

“What is happening right now in equity markets is exactly why stocks outperform other asset classes over longer periods of time…they’re riskier,” says Schutte. “Investors who stay calm through times like these usually collect excess returns that other, more skittish investors, forgo.”

And how do you stay calm? Stay focused on the tanker ship, not the jet ski doing figure eights – flashy as it may be. And based on the LEI reading, this tanker ship of an economy is still headed in the right direction.

“We don’t believe the recent volatility in markets signals the start of a recession, and that is the most important thing we can say about our future market outlook,” says Schutte. “There have been seven bear markets since the mid-1960s and five of them have coincided with economic recessions.”

In both 1966 and 1987, Schutte says, the market dropped by 20 percent or so, but the decline didn’t coincide with a recession in the broader economy. Because the underlying economy was still strong, it dragged the market out of its rather brief malaise and pushed it higher. Schutte thinks the current climate we’re in is like these two points in history.

Schutte believes there will be increasing clarity on international trade and a new path forward will likely emerge in the coming quarters. Even if the trade environment remains muddled, companies will adapt their businesses to minimize the impact tariffs have on their bottom line. Schutte also thinks the Fed, and other central banks around the globe for that matter, will approach interest rates with utmost caution to avoid disrupting economic growth.

“No central bank wants to cause a recession,” says Schutte. “Equities will eventually grind higher as the economy continues to push forward over the coming year or two years at least.”

In the meantime, spare your eardrums the market’s howls.

The opinions expressed are those of Northwestern Mutual as of the published date and are subject to change. There is no guarantee that the forecasts made will come to pass. Past market performance and economic indicators are not a guarantee of future results either. This material does not constitute investment advice. Investors should carefully consider their ability to invest during volatile periods in the market.