Predicting the future success and failure of economies and stock markets is often pinned to certain indicators – but how accurate are they in doing their job?
Let’s face it, we’d all like to see into the future. But as we’ve not yet worked out how to build a Tardis, that’s unlikely to happen any day soon. In the meantime, we have to rely on supposed expert opinion to predict what’s going to happen in certain areas of life.
No one’s perfect. On the evening before the Great Storm of 1987, weatherman Michael Fish famously noted during a weather report: “Earlier on today, apparently, a woman rang the BBC and said she’d heard there was a hurricane on the way... Well, if you’re watching, don’t worry, there isn’t!” That evening, the worst storm to hit south-east England for three centuries caused record damage and killed 19 people.
Despite a wealth of economic indicators to draw upon, it seems most economists and financial commentators are just about as successful as Fish when it comes to predicting recessions and recoveries, never mind stock market falls.
A 2014 study by two IMF economists, Hites Ahir and Prakash Loungani, found that none of the 62 recessions that occurred around the world during 2008 and 2009 had been predicted by mainstream economists by September of the previous year.
Warnings dismissed
Justin Oliver, Deputy Chief Investment Officer at Canaccord Genuity Wealth Management, believes this is perhaps not a wholly fair representation. He argues that some economists who have in the past spotted problems were derided or ignored.
He cites Tony Dye of Phillips & Drew in the 1990s, and William White, Chief Economist of the Bank for International Settlement, before the financial crisis, as two such figures who did warn of imbalances.
Of the handful of economists who did warn of problems prior to the great financial crisis of 2008/09 – including Steve Keen, Ann Pettifor, Nouriel Roubini, Dean Baker, Raghuram Rajan and Peter Schiff – most were outside the mainstream. The vast majority of economists and financial commentators somehow missed the warning signs of an impending financial crisis, never mind anticipating it leading to multiple recessions around the globe.
Josh Ryan-Collins, a Senior Economist at the New Economics Foundation, believes the main reason for this lack of forecasting ability by most economists is the models they use. “Mainstream economics has largely ignored the role of credit and its counterpart, debt, as well as asset prices and the financial sector more broadly in macroeconomic modelling, including forecasting,” he explains.
“A false division was drawn between the real economy – involving labour, exchange and trade – and the financial economy, which was seen to be relatively neutral in the long run, with credit and money ‘oiling the wheels’ of the real economy.
“The financial crisis is the classic example – the huge build-up of mortgage credit and corresponding increases in house prices was largely ignored because modellers were focused on consumer price inflation (in the ‘real’ economy) and GDP growth, both of which seemed relatively healthy.”
Ups and downs
Economists typically tend to use a wide variety of lagging and leading indicators to try and ascertain what’s happening with an economy. Lagging indicators shift after the economy changes. Although they don’t typically tell us where the economy is headed, they indicate how the economy changes over time and can help identify long-term trends.
Some of the most popular lagging indicators include changes in GDP, the consumer price index (CPI), income and wages, unemployment rates and the balance of trade.
Leading indicators tend to predict future changes in the economic cycle. They include indicators measuring consumer confidence, IHS Markit’s Purchasing Manager’s Index (PMI), bond yields and stock market performance.
Anyone who watches the investment markets knows that they move up and down on a whole series of economic data. This is both hard or quantitative data – such as employment and unemployment figures, interest rate changes and manufacturing stats – and soft data, such as surveys giving an indication of business sentiment.
However, the feedback loop between the two is complicated by the fact that the economic cycle doesn’t coincide with that of the financial markets, whose participants are continually attempting to second guess where an economy is heading.
According to Andrew Lapthorne, Head of Quantitative Research at SociÉtÉ GÉnÉrale: “Most economic leading indicators have bond and equity markets as the key indicator of future recessions. We find that, even if you knew the business cycle in advance, it lags the market cycle. As such, my view is that economic data isn’t that useful for market timing.”
Unemployment stats
Possibly one of the most misleading stats regularly put out is on unemployment levels, as Professor Steve Keen, Head of Economics at Kingston University, attests. “It used to be that if you were out of work and looking for work, you were classified as unemployed. Now the International Labour Organisation definition requires that you haven’t done an hour’s paid or unpaid work in the previous two weeks, that you are available to start immediately, and many other extraneous points.
“The US even drops you off their main measure – known as U3 – if you’ve been unemployed for more than a year. All these factors make modern unemployment statistics misleading, and hard to compare with historical statistics.”
Still, there are economic indicators that apparently have a close correlation to recessions and recoveries. Albert Edwards, Global Strategist at SociÉtÉ GÉnÉrale, has written: “It is the business investment cycle driven by the profits cycle that is, historically, the primary cause of recessions.”
Thus, in a September 2016 note, he argues: “Our hypothesis that a US profits recession will lead to a collapse in business investment and take the economy into recession seems to be playing out.”
On his reading, consumer consumption is all that’s keeping the US economy afloat.
Reading between the lines
Given that in the short term much of this consumption is driven by increasing debt, Justin Oliver argues that in order to gain an idea of where an economy is heading in the short term, one of the best correlations is the ‘credit impulse’ – the rate of acceleration of credit or private debt in an economy.
Keen elaborates: “The credit impulse leads changes in GDP and changes in employment, with the lead (in the US) being about two months in the case of employment and four months in the case of GDP.”
Of course, given the complexities of economies and financial markets, no single indicator will tell you exactly what’s going to happen with either, so it’s difficult to spot precise tipping points. Still, Oliver believes a good forecaster can “accurately assess the direction of travel”.
Derry Pickford, Co-head of Asset Allocation at Ashburton Investments, is slightly more cautious. “You can certainly identify risk, and you can sometimes identify direction of travel, but even direction of travel over shorter time horizons can be very tricky. If you’re just using quantitative data without any qualitative judgement, you can do longer-horizon forecasts, but they still have substantial risks around them.
"When it comes to shorter time horizons, quantitative data becomes less and less useful and you have to be more and more reliant on your qualitative analysis.”
Crisis ratio
Nevertheless, Steve Keen is confident he’s identified that economic crises occur when the ratio of private debt to GDP is large, and is also growing quickly compared with GDP.
By screening for countries where the private-debt-to-GDP ratio exceeded 175 per cent of GDP, and where the increase in private debt last year exceeded 10 per cent of GDP, Keen came up with a list of the seven countries that are most likely to suffer a debt crisis in the next one to three years. They are – in order of likely severity – China, Australia, Sweden, Hong Kong, Korea, Canada, and Norway.
However, he does admit: “Timing precisely when these countries will have their recessions isn’t possible, because it depends on when the private sector’s willingness to borrow from the banks – and the banking sector’s willingness to lend – stops.”
The curse of Cassandra has historically led to the majority ignoring such warnings, even though conventional economic wisdom has proven to be inadequate.
Perhaps, the last word should go to the great economist John Maynard Keynes, who observed: “Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.”
Unusual economic indicators
• New car sales If car sales are increasing, it shows people are confident about their jobs and promotion. If it is trending down, it could be a sign that they are losing confidence in the economy. Motor vehicle sales are good indicators of trends in consumer spending and often are considered a leading indicator at business cycle turning points.
• Underwear Index This can supposedly detect the beginnings of a recovery during an economic slump, as sales of men’s pants, which are a flexible necessity, increase during an upturn. It was once used by Alan Greenspan, former Chairman of the Federal Reserve, to predict market trends.
• Baltic Dry Index This provides a measure of the freight rates for moving major raw materials by sea. The BDI is considered by some people as a leading economic indicator because it predicts future economic activity – rising rates indicate increased demand and therefore future economic growth and falling rates indicate contraction.
• Skyscraper Index In 1999, economist Andrew Lawrence created the Skyscraper Index, which purported to show that the building of the tallest skyscrapers is coincidental with the onset of major economic downturns.
• Lipstick Index In 2000, Leonard Lauder, Chairman of cosmetics firm EstÉe Lauder, argued that increased sales of cosmetics, especially lipstick, could be inversely correlated with economic health. He argued that women would defer buying more expensive items such as dresses, handbags and shoes and instead buy lipstick in times of hardship. A more recent variant on the same theme is the Nail Polish Index.