Which Economic Indicators Matter?
by Charles Rotblut, CFA and Aaron Smith
Charles Rotblut will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
Aaron Smith is a senior economist for Moody’s Economy.com. He spoke to me recently about the economic indicators he watches and what they may be signaling for the direction of the economy and markets.
—Charles Rotblut, CFA
Charles Rotblut (CR): What economic data do you consider to be the most important to look at?
Aaron Smith (AS): The data on employment is key because the jobs being created are what will generate the income necessary for spending. It’s that cycle that we need. You hear the term “escape velocity” for the phase when spending and hiring start to reinforce one another. It’s also the same point at which we typically say a recovery has made the leap to an expansion.
The weekly data on jobless benefit claims is really the best, most timely data that we have. It’s extremely accurate because it’s an actual count. It’s weekly versus monthly, and the data really gives us a feel for where labor conditions are in real time.
CR: Are you looking mostly at the four-week change in initial jobless claims? What exactly are you looking at in those numbers?
AS: I look at the initial filings for unemployment insurance and then the ongoing claims for unemployment benefits. The ongoing claims, or continuing claims, give you a better feel for how much slack there is in the labor market, so that pertains more to the unemployment rate; whereas the data on initial jobless claims pertains more to the change in employment from month to month, so that pertains to job growth. But any time you’re talking about data that’s weekly in nature, it makes sense to look at them on a four-week moving average basis to get a better feel for the trend. Now, that said, the data is very accurate because it is an actual count so there is value in a single data point. That’s part of the reason why the data is so important to gauging current economic conditions.
CR: What about the people who have been unemployed for a long time? In an economy like this where jobless benefits are running out, how do you account for those people?
AS: It’s a problem. The long-term unemployment problem is very real. We have started to see some improvement in some of the barometers inside the jobs report that we look at and some of the leading indicators—the breadth of hiring and whether firms are employing their existing employees more intensively (making them work longer hours), which is reflected in a rising or lengthening work week. But the long-term unemployment issue just keeps getting worse.
The median duration of unemployment continues to rise and we still see a big wedge between the number of people unemployed for, say, 26 weeks or longer versus those who have only been unemployed for a few weeks. The number of people who are unemployed for just a few weeks has leveled off and even started to come down a little bit; whereas the number of people who are unemployed for a long amount of time continues to rise. That’s a problem because it reduces their employability down the road and creates a structural unemployment issue apart from a cyclical unemployment issue. This is something that’s going to slow the recovery in the labor market, say, as we get into 2011.
CR: If someone’s looking for data on the long-term unemployed, what reports should they read?
AS: Continuing unemployment benefit claims are anything after the first week. You can get a feel for the long-term unemployed by looking at the continuing claims and then the emergency federal benefits that were enacted awhile back. What we look at is embedded in the monthly employment jobs report, which has statistics on both the average and median duration of unemployment. There’s also a breakout in that report of the unemployed by time for different ranges (Figure 1). Those are the two main sets of data inside the employment report that we focus on when we try to get a handle on the long-term unemployed.
CR: The monthly jobs report contains the change in non-farm payrolls and the unemployment rate. Since the numbers are gathered from different groups of people, can you explain what the two statistics actually measure?
AS: Every month when we get the jobs data, two surveys are released. The payroll survey—the headliner—is the jobs number or net job creation in any given month. You take all the gross hires and subtract all the separations in that month and the difference between the two is net job creation, which is the jobs number that you hear on the nightly news.
Now, the unemployment rate comes from the household survey, which is a completely different survey.
We tend to focus on the payroll survey for various reasons. It tends to be more reliable and much less volatile. But we do get the unemployment rate from the household survey, and that’s determined by looking at the number of unemployed and dividing that tally by the total labor force. The labor force consists of those who are employed and those who are unemployed but actively seeking employment.
CR: What other reports do you consider to be important besides the employment numbers?
AS: Employment is at the top of the list. Below that are the Institute for Supply Management () surveys, which are purchasing managers surveys for both the manufacturing and the non-manufacturing sectors. These are timely. We get employment for the preceding month usually in the first week of the next month. These national surveys for both the manufacturing and non-manufacturing sectors come out at about the same time so they’re very timely and we get the first glimpse of activity for the preceding month. That’s the data that we focus a lot on.
The ISM surveys correlate very well with gross domestic product Figure 2). There’s also the composite for each survey which is built up of component parts. Things like new orders, business activity or production, and inventories. The ISM surveys also have employment indexes. These all give clues to what kind of feel the actual hard data, which typically comes out later, is going to have or clues as to where we are headed. Is growth picking up or is it slowing?, which is rather important (
However, we don’t get the hard data—the data that the government uses to come up with GDP—until four to six weeks after the month has ended. So reports like employment and the ISM surveys on manufacturing and the service sector can help us forecast and gauge what the hard data or the activity data is going to say.
CR: Regarding the ISM surveys, are you focused on the headline numbers or are there certain components you look at?
AS: A key metric that we look at is the difference between new orders and inventories. It’s a leading indicator for future output or production. The idea is that in any given month producers or factories are producing goods to meet demand. If you’re producing a certain amount of goods and you sell a certain amount of goods, there’s a difference there—you’re either adding to inventories or you’re drawing down inventories. In these surveys if you have inventories falling and new orders rising, chances are production levels at their current pace aren’t sufficient to meet your needs. So that’s going to give information on where growth and production are likely to head next.
CR: Are there any other reports you consider especially important?
AS: We typically classify reports as first tier, second tier and third tier, although it’s not set in stone by any means. The ones I just mentioned we consider first-tier reports. There are plenty of second-tier reports that are very important for gauging what the economy is doing but they’re a little more lagging, such as activity reports. We take those results and determine what the implication is for GDP at any given time. So for things like retail sales for consumers and factory data, durable goods orders data comes out first and then we get the complete factory data set a week later. That’s important for business investment. Construction spending also is important for business investment. Those three reports are important to gauging where GDP is at in any given month.
CR: What about some of those industry reports that come out? A good one to start off with is the Baltic Dry Index which fell for 35 days in a row recently. What’s your viewpoint on this and other industry reports?
AS: I’ve written on the Baltic Dry Index before. I’ll admit that I don’t look at it on a daily basis. Part of the reason why is because if you know what commodity prices are doing, more often than not, the Baltic Dry Index is going to be moving in a similar direction. That’s not always the case, however. There are demand and supply curves for various commodities and then the shipping side is a completely different animal. But they’re highly correlated and the Baltic Dry Index tends to be extremely volatile. The index is a good indicator for where we are at in the industrial cycle as well as trade. But typically the trade data and the factory data go hand in hand. The trends typically follow each other pretty closely.
There are not a lot of industry-specific reports that I look at, but there are some. For example, I look at things like the Smith travel data on hotel occupancy rates to get a feel for leisure and hospitality—both on the employment side or the growth side, and on the inflation side.
Other data that I’ll look at, and this kind of goes along with the Baltic Dry Index, are freight tonnage and rail traffic, things like that. And then I look at specific stuff, and this stuff is very specific: Boeing’s orders and shipments, auto incentives, some of the Edmunds data or some of the data from Wards. Admittedly, a lot of this we use in our modeling and in our forecasting if we’re trying to get a feel for what inflation is doing in a given month and building up our forecasts from the component parts. A lot of these industry-specific sources feed into that process. On my end, that’s where I tend to use it on a daily basis. But the more timely the data is, the better the information that you’re going to get from the standpoint of an investor. If you’re trying to get a feel for where the economy sits right now—and what that means for your portfolio and where you should be putting your money—the more timely the data, the better. Weekly data is preferable over anything else.
CR: Do you look at the Redbook retail sales indicator that comes out weekly?
AS: The chain store data has lost a little bit of its luster because Wal-Mart is no longer included. However, it still is much more timely than the Census Bureau’s retail data. The weekly indicator does tend to give us an advance warning if there’s a slowdown on the horizon or if momentum is picking up speed in a positive direction. It’s a good indicator to watch, but I wouldn’t base an investment thesis on it.
CR: Speaking of timeliness, I know one of the inherent problems with economic data is that it always tells you what has happened in the past. How do you tell if something’s actually changing versus whether it has already changed and you’re just now seeing it in the data?
AS: It’s difficult. First of all, you explained exactly why we put more stock in the timely data and the data that gives us the first glimpse of conditions in any given month. Now, because the data can be revised and because it’s not always timely, it’s important to group it together. For example, the employment data is typically done in the second week of the month. When we got the June data in early July, it really represented hiring and firing in the second week of June, not for the entire month. And a lot can happen in just a few weeks’ time, which brings me to my next point.
We pay very close attention to both confidence and financial market conditions—specifically, the interplay between the data and financial market conditions. For example, the employment data was for the second week of June, which was three or four weeks ago from the time of this interview. Financial conditions have weakened since then, so we take that into account when we’re making decisions about forecasts and anything else.
Confidence is also very important, particularly at turning points. Most of the time confidence measures do not give you much information; they tend to be reactive in nature. They tend to reflect what’s currently going on. But when conditions are changing—at turning points and when there are ebbs and flows—there’s a significant slowing in the pace—which appears to be the case right now. That’s when the importance of confidence increases. We are on high alert right now for any downside break in confidence that could indicate a shift in behavior by businesses and households from this lukewarm expansive mindset that we’ve seen develop over the past several months back toward something more restrictive. So far it appears that the private sector is taking this latest market setback in stride.
Specifically, the indicators to watch are the Conference Board consumer confidence, which comes out once a month, and the University of Michigan consumer sentiment. Those are the two consumer monthly surveys that we put the most stock into. Now there are some weekly surveys as well, including the ABC Washington Post survey that comes out every Wednesday (Figure 3). Those correlate pretty well to the monthly data. Now, in the current environment, consumer sentiment has lagged in this recovery for obvious reasons and because of that it’s a little more difficult to glean any sort of turn or shift in the trend.
Where we’re really watching closely is on the business side. Unfortunately, there are not a lot of timely surveys on business confidence. We have our own survey, but it’s a proprietary survey; it’s not public. But aside from that, there are a few quarterly surveys that I know of—one is from Business Roundtable, and I think the Conference Board also does a survey of CEOs. The important takeaway is that confidence increases in importance during times of increased uncertainty.
CR: Many of our members are worried about the deficit and they think inflation is also going to rise. What should they be looking for as a signal that interest rates are going to rise?
AS: There are two things to watch. One, if we get a shift down in the unemployment rate that is significant and lasts three or four months, 90% of the time the unemployment rate will head even lower. Those are the days when you get Treasury yields skyrocketing. But the problem with that is that it is backward-looking.
From a policy perspective, inflation is also very important, especially if we start to get a turn or a change in the trend in any of the inflation metrics. The most important indicators to watch are the consumer price index (and personal consumption expenditures , which comes out with the Personal Income and Consumption Report each month. The CPI is issued as its own report.
Aside from that, it’s also very important to watch inflation expectations very closely. That’s something the Federal Reserve is watching extremely closely as well. The issue there is that if businesses or households start to incorporate higher or lower inflation in their planning processes, if that starts to become embedded in their psyches, there’s a self-reinforcing element to it. If you get a move down in inflation that’s accompanied by an actual shift down in inflation expectations, at that point you will see Fed rate-hike expectations push back considerably.
From the outside looking in, when it comes to fiscal issues and whether interest rates are heading higher because of crowding out and fiscal concerns, watch long-term bond yields. If those are low or heading lower, then most likely policy needs to continue to do what it takes to get recovery off the ground. This is the story right now, or at least so far. Obviously, there’s some backlash lately.
CR: In terms of the Fed actually raising rates, are you focusing more on the data that’s coming in rather than on any particular wording change the Fed is putting in its statement or something that’s said in the minutes?
AS: We do take into account changes in the ranks. If 2010 or 2011 has more hawkish voting members versus dovish members, we will take that into account. But it’s a marginal thing. Will they raise rates in January versus April rather than early 2011, late 2011? So, you’re right, it’s more the data and where we think growth is heading—which has implications for where we think inflation is heading.
CR: I know we’ve talked about this a little bit, but I’m going to ask it directly: Going the other direction, what would be a sign to you that we’re heading back into a double-dip recession? What indicators would alert you to that fact?
AS: The stock market is probably the biggest sign. Right now, in July, we’re kind of at that point where the market is in a traditional garden-variety correction, but we’re leaning toward something more significant or more severe. We’re kind of backing off that a little bit. But if you get a move down in stock prices of more than 20%, typically that’s going to have a significant negative effect on confidence. If that happens in the current environment, when the private sector doesn’t have quite enough juice to prop us up or offset the saving policy and fiscal stuff, then we’re in a little bit of trouble. So, we look at the stock market and financial conditions broadly. Credit spreads and bank funding pressures should be considered to get a feel if banks are tightening the vice.
As far as the data goes, the unemployment benefit claims data is key. If we were to break higher in claims, it’s telling us that businesses in the current environment are backing off some of their expansionary plans and turning more cautious or to defensive posturing.
CR: If someone wanted to get information on bank lending, particularly trying to judge how tight or loose credit is, is there any good measure that’s easily available to the public?
AS: Yes, there is actually weekly bank lending data. Now the tough thing there is that it’s measuring bank loans outstanding, so it’s similar to the jobs data where you have two sides and you’re looking at the net. When you’re looking at bank lending data, you have new lending versus the paying-down of existing obligations—both the amortization of existing debt and any charge-offs that banks are taking. Those two things, both the paying down of existing debt and the charge-offs banks are taking, are netted against new lending to calculate bank loans outstanding.
That doesn’t mean there’s no value in that data at all. Specifically, one component of the weekly data (it’s Fed data by the way) is the data on business loans or commercial and industrial loans, commonly called C&I loans. This is typically a fairly decent barometer of credit conditions facing businesses. It’s taken on added importance in the current environment because while large businesses have begun to borrow on net again—even though they’re not borrowing in any big way—small businesses continue to retrench. Part of that is a demand issue and part of it is a supply issue, but we are watching that specific data set fairly closely—mostly because it’s weekly.
The better data to get a feel for credit conditions and whether banks are tightening or loosening is the senior loan officer survey. This is also Federal Reserve data, but it’s a quarterly survey of domestic banks. It’s a big report with very detailed data, so they’re asking questions like: Are you tightening terms? Are you tightening standards? The report also covers the spectrum of loan types as well: consumer, business, commercial real estate, residential real estate—even broken down by residential real estate types, like prime borrowers and subprime borrowers. This report is a very good source to get a feel for credit and what banks are doing. It lines up fairly well with some of the hard data on both investment by businesses and spending by households. This is particularly the case early in a recovery when the cyclical forces are the strongest and when we typically see the highest growth rates in some of the big ticket items—such as autos, housing, home sales, and, on the business side, capital equipment.
CR: If an investor is looking at economic data, any thoughts on how they should apply it toward managing their portfolios?
AS: Early in an expansion, there are some rules of thumb. If you’re confident that the recession is ending and a recovery is taking hold, then that’s the time that you want to be more aggressive—depending on your risk tolerance, obviously. If you take a broad look at the data and you’ve looked at the indicators and the news flow is still a little negative, but you’re increasingly confident because you’re seeing a turn in the data, that’s when the opportunity for gains is the greatest if you jump back in the risky assets. But early in a recovery it’s good to be in corporate bonds and equities. Within equities, look to cyclical industries and anything tied to the consumer; consider tech, because investment tends to come back early in an expansion; and look at consumer spending, like retail and leisure hospitality.
Housing would normally be included too, but not so much in the current environment because of the special circumstances. This recession was driven or at least preceded by a bubble in housing, so it typically takes more time for those excesses to unwind if that’s the catalyst. So that’s an exception to the rule, and you have to watch out for things like that.
Aaron Smith is a senior economist for Moody’s Economy.com and associate editor of the North American edition of the Dismal Scientist website, producing real-time online commentary and weekly analysis on the U.S. macroeconomy.