It's Time For A Closer Look At The Leading Indicators
Jul. 22, 2015 3:14 PM
- Those investors worried about the strength of the economy should take a closer look at the Leading Indicators.
- Building permits have increased substantially in the last two months, providing additional support to the ongoing recovery.
- In spite of a potential rate increase, the Fed remains highly accommodative.
So here we are, halfway through 2015, and the major market indexes are right about where they were on January 1st. No doubt this has been frustrating for most investors, and is leading many people to question the longevity of this market. It seems as though people have forgotten that the S&P 500 was up 30% in 2013 and 14% in 2014. The fact it, the markets deserve a breather once in awhile. And just because the equity markets are trading sideways right now that doesn't mean that investors should be throwing in the towel.
In times like these, investors ought to be looking to the Leading Indicators for some guidance. And as we discuss in this article, the evidence suggests that investors would do well to maintain a bullish stance.
Figure 1 - The Yield Curve
Whenever we look at the Leading Indicators we always like to start with the Yield Curve. There's a lot of useful information packed into this indicator as it provides a top-down perspective of monetary policy. A positive slope to the Yield Curve reveals an accommodative Fed whereas a flat and/or negative slope to the curve tells us that the Fed is more interested in slowing down the economy. As our regular readers know, we measure the Yield Curve as the spread between 10-year Treasury yields relative to the Fed Funds rate.
At this juncture, we all know that the Fed remains exceedingly accommodative with the policy rate in a zero-bound range of 0 to 25 basis points. And we also know that Dr. Yellen & Co. would really like to get us up and off the zero-bound range later this year. And following that, the Fed would also like to continue raising rates until they discover what the new rate of policy "normalization" ought to be. That's all fine and dandy; however the Global capital markets aren't ready for this at all. In fact, with only a 238 basis point spread on the Yield Curve, the Fed seems way out of step with current and historical reality. The Fed does not normally raise rates until there is at least a 350 to 400 basis point spread to the curve. Moreover, at this point of the business cycle, the Fed is normally a "follower" of the capital markets. The Fact that Dr. Yellen would like to be "ahead of the curve" this time around may just be wishful thinking.
The U.S. dollar is already quite strong, so it really wouldn't make sense for the Fed to throw even more gas on the fire.
Figure 2 - Initial Jobless Claims
Initial Jobless Claims continue their slow yet steady decline, reaching a recovery-low of 282,500 as measured on the basis of its 4-week moving average. This is just the sort of thing we like to see at this point of the cycle. It's also worth noting that initial claims data represents one of the most seasoned and most reliable indicators that we track.
There also seems to be room for additional improvement here. In fact, we would not be surprised to see initial Claims fall below 250,000 at some point in the near future. Clearly this recovery, now into its 7th year, has been agonizingly slow, but that is what we get for having just endured the worst financial crisis since the Great Depression. It just takes time for the economy to heal.
Figure 3 - Spreads Between 3 mth LIBOR and 3 mth Treasury Bills
Spreads between 3-month LIBOR rates and 3-month Treasury Bill rates continue to suggest a fairly stable credit environment for investors. We think it is rather important to note that this important indicator of financial stability hardly budged during the recent issues with Greece and the Chinese stock market. While all of the "talking heads" in the media thought we should be trembling with fear, our credit markets provided one of the few voices of reason. Granted, the equity markets were bouncing back and forth based on the daily drama, but that, too, appears to have subsided now that earnings season is under way. Clearly, investors have more important things on which to focus.
To be sure, when the fed does begin to tighten monetary policy, the markets are likely to exhibit all sorts of volatility, in both equities and fixed income. A lot of market trades betting against a rate hike will obviously need to be unwound. However, at this point, it seems unlikely that we would see any significant stress fractures emerging within the credit markets simply based upon a few near term rate increases.
Figure 4a - High Yield Risk Spreads
It's no secret that we are not fans of the High Yield sector at this point in the cycle. With average option adjusted spreads of 493 basis points, the risk - reward profile remains out of whack. To be sure, risk spreads widened by roughly 100 basis points or so in conjunction with the dramatic declines we saw in crude oil prices. The back-up in spreads is obviously a function of each individual issuer's credit profile, but the High Yield space really took it on the chin. And of course, those individual issuers in the energy space bore the brunt of this correction. And now with crude oil prices heading lower again, we should expect to see more volatility in High Yield.
Figure 4b - BB Effective Yields vs. BBB Effective Yields
For those investors still convinced that High Yield bonds provide a suitable risk/reward profile right now, you may want to consider the graph in Figure 4b. At this point of the credit cycle, investors in BB credits are getting a mere 120 basis points of yield pick-up relative to BBB credits. Just so we're clear, an extra 120 basis points doesn't even come close to compensating High Yield investors. When you move from investment grade
to speculative grade, one needs to be compensated for the dramatically higher default risk. And quite frankly, 120 basis points are just not enough.
Figure 5a - Building Permits
Building permits have shown some surprising strength in the past two months with May data rising to an annual rate of 1.25 million units. June data was even stronger with building permits rising to an annualized rate of 1.343 million permits. Likewise, housing starts, and sales of new and existing homes are exhibiting some stronger signs of activity versus a year ago.
The old saying that "a picture is worth a thousand words" is nowhere more evident than the chart of Building Permits. Much like many sectors of the economy, Building Permits activity didn't really start gaining traction until 2012. And even so, the gains have been agonizingly slow. And just when some people are ready to throw in the towel, the economy picks up again. It would seem that ongoing gains in employment levels along with historically low interest rates have provided the housing sector with just enough strength to continue marching forward. If that chart is not enough to provide a thousand words, take a look at Figure 5b.
Figure 5b - Furniture and Furnishings Store Sales
It would appear that consumer spending on new and existing home sales correlates quite strongly with retail sales of furniture and home furnishings. This shouldn't be too surprising. After all, when people buy a new home they usually like to upgrade some of the old and tired looking furniture they have held onto for so many years. Figure 5b also shows that during the recession of 2001/2002, furniture sales merely paused in tandem with housing sales. And when the recovery got under way in 2002/2003, both housing and furniture sales resumed their upward trajectory right up into the peak of the housing bubble.
We're not exactly adopting furniture sales as a new Leading Indicator. But it does, however, provide a solid confirmation of where the housing market is headed.
Figure 6 - ISM Manufacturing New Orders
The ISM Manufacturing indicator of New Orders represents one of those reliable, well-seasoned indicators that we've tracked for a long time. It seems to have a better grasp of manufacturing new orders than does its counterpart, durable goods orders. Indeed, the ISM data is not usually subject to massive monthly revisions, which often leave investors confused about the underlying economic trends.
The latest read for June 2015 new orders held steady with May data at 56.0. Because this indicator is a diffusion index, readings above 50.0 suggest that we're likely to see decent manufacturing activity going forward. Granted, the current data is not as strong as we saw last year (with readings above 60), but the trend remains positive.
Figure 7a - C & I Lending Survey
It's always good to know what commercial loan officers are thinking, and the quarterly survey published by the Federal Reserve provides just that sort of information. It turns out that the FRB survey tracks the C& I lenders, and whether they are more inclined to loosen or tighten their credit standards. The latest data tells us that C & I lenders are closing in on a stable credit policy, but with a slight preference to easing credit terms. If Dr. Yellen & Co. does indeed raise the Fed Funds rate later this year, it will be most interesting to see how the C & I lenders react. If loan demand remains as strong as it is now, bankers could very well play along with the status quo. After all, if the fed raises rates by a mere 25 basis points, why should commercial banks tighten their credit standards?
Figure 7b - The Prime Rate vs. Fed Funds
Now just because the banks may keep credit standards right where they are, we believe it's highly likely that commercial banks will raise the Prime rate in step with any Fed move higher. The chart above clearly illustrates how commercial banks tend to maintain the Prime rate at a spread of 300 basis points above the Fed Funds rate. They did that before the Great Recession, and have stuck with that target since January of 2009.
Figure 8 - The S&P 500 Index
Our final Leading Indicator tracks the S&P 500 relative to its 200-day moving average. In that regard, the 200-day trend line proved to be a strong support level earlier this month when the markets were being challenged by the geo-political theater between Greece and the EU, not to mention all of the negativity surrounding the disappointing retail sales activity. As we mentioned earlier, our financial strength indicator held firm amidst the drama, so it was refreshing to see the equity market respond accordingly. As of Friday, July 17th, the S&P closed at 2126.64, providing a 3.4 % cushion above the 200-day moving average of 2056.72. It will be very interesting to see how things "shake out" as we head in to the thick of earnings season.
The Bottom Line
The Leading Indicators continue to provide optimism that economic growth will continue to move forward. Conditions in the labor market continue to improve. New Orders activity, according to the Institute for Supply Management, also suggests that manufacturing is likely to contribute to further economic expansion. And it also appears that the housing sector is gaining some real traction based on the rising levels of Building Permit activity. While the auto sector has been one of the key drivers in this recovery, improving fundamentals in housing could bring things to a whole different level. But above all else, Dr. Yellen & Co. remains highly accommodative. The fact that the Fed is only just now getting serious about raising the Fed Funds rate tells us that this economy has legs. We've said this before, and we will continue saying it until both of our Leading and Late-Stage indicators suggest otherwise.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.