August 16, 2013
Strong economic data made the markets nervous last week as they worried about higher interest rates. While the stock market is always volatile, it is also a leading indicator of the economy which means that it begins to fall long before the economy turns downwards. So which is it this time? Real? Or noise? It’s noise. Here’s why.
Because the stock market is a leading indicator of economic activity the recent drop should get our attention, particularly since it occurred shortly after a percentage point increase in long-term interest rates. However, the decline thus far is a mere 1.8% which is not even close to the 10% mark that would be categorized as a “correction”. Furthermore, between mid-May and m id-June, when the Fed first told us it intended to slow the pace of easing later this year, the S&P fell 4.2% only to rebound and hit a new high a month later. In our opinion, the current drop is nothing more than typical stock market volatility.
While the stock market is a leading economic indicator there are many others, none of which are signaling any particular danger. For example, consumer sentiment declined 5.1 points in August from 85.1 to 80.0. What is surprising is not the drop in August, but why sentiment remained so high in May, June, and July. The one percent increase in mortgage rates from 3.5% to 4.5%, and the prospect of additional Fed measures to push interest rates higher, has finally caught the consumer’s attention. However, at 80.1 we maintain that GDP growth will quicken from 1.4% in the first half of this year to 2.3% in the second half.
Another leading indicator is the housing sector. Prospective buyers have seen home prices rise at a double-digit rate in the past twelve months and mortgage rates climb by a percentage point from 3.5% to 4.5%. As a result, the fence-sitters have jumped into the market which has created a shortage of available housing. Builders are racing to catch up but, thus far housing starts have seriously lagged the increase in demand. This is happening in part because builders are having difficulty finding adequate financing, but also because they are unable to hire a sufficient number of skilled workers.
Initial unemployment claims, which are a measure of layoffs, are a leading indicator of changes in employment. If firms are beginning to lay off workers, then employment should soon rise more slowly or perhaps even start to decline. But currently layoffs are at their low for the cycle which suggests that, if anything, employment gains in the months ahead are likely to get bigger, not smaller.
The backlog of orders is another leading indicator of economic activity. If manufacturers have more orders coming in than they have shipments going out, the backlog rises which should cause them to quicken the pace of production. The backlog has risen sharply in recent months, which is a sign that the manufacturing sector is beginning to accelerate.
Finally, the spread between long-term and short-term interest rates, known as the “yield curve”, is an important indicator of future economic activity. When the Fed tightens, or investors fear the Fed will tighten, short-term interest rates rise faster than long rates and the yield curve flattens. Prior to the onset of the 1990-91, 2001, and 2007-08 recessions Fed tightening caused the spread between the 10-year note and the funds rate to became slightly negative With the 10-year currently at 2.8% and the funds rate at 0.1% the yield curve currently is 2.7%. It is not going to slow the pace of economic activity. We do not have to worry about a recession (or a significant growth slowdown) until the yield curve flattens sharply – which will probably not occur until the Fed actually begins to raise the funds rate in mid-2015.
While the stock market is an important leading economic indicator, it is one amongst many. It is part of a much larger jigsaw puzzle. It has fallen somewhat in the past week, but none of the other indicators are pointing towards any particular danger. Thus, the recent drop is nothing more than typical stock market volatility. We will not become alarmed until the stock market declines by at least 10%, and is confirmed by alarm bells from some of these other leading economic indicators.
Stephen Slifer
NumberNomics
Charleston, SC
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