Weekly Market Perspectives: The Forecasting Fallacy – Gap between current and leading indicators diverges
Published: August 28, 2023
All eyes were on Jackson Hole this week as prominent central bankers from around the world gathered to discuss the future of domestic and global monetary policy. The meetings culminated in several speeches by central bankers, but Jerome Powell’s keynote on Friday morning drew most investor attention. Powell delivered what was expected – central banks have more work to do and indicated that key interest rates will be held at current levels (or higher) until inflation is persistently in a tolerable range (i.e., close to 2%). Powell noted that policy will remain flexible and data dependent as the FOMC contemplates further rate changes, but he indicated that there is virtually no desire to start easing policy anytime soon. However, with prices increasing at much slower pace relative to 2022 levels, policymakers are closer to declaring victory, particularly with strong economic data supporting a soft landing. Regardless, there will be a balance that central bankers will have to achieve between doing too much and doing too little. Soon after Powell’s speech, investors pushed the probability of another rate hike slightly higher at the next September and November Fed meetings but, with some uncertainty surrounding policy eliminated, markets rallied to finish the week higher – the S&P was up by +0.8% and the US Aggregate bond index by +0.3%.
High and rising yields in recent months have increased pressure on risk assets, although equity markets continue to hang on to strong year-to-date gains. The market rally has been largely unexpected as analysts and economists held widespread views of economic weakness at the start of 2023, although those calls have been waning amid robust economic data. While recent performance is helpful in setting short-term expectations, medium- to long-term forecasting is more difficult. That does not stop Wall Street from trying… Economists and analysts are being pulled in different directions as evidenced by the wide gap between the highest and lowest economic forecasts. The challenge is made even more difficult because current data continues to come in stronger than expected but the leading economic indicators (LEI) have been suggesting weakness since the middle of last year.
The Citi Economic Surprise index, which measures the difference between official economic results and forecasts, has been positive since February and has shown meaningful reacceleration in Q3. Recent reports on lower US inflation (CPI and PPI), falling import prices, and better-than-expected jobless claims helped push the surprise index to the highest level in two years.
Another look at current economic strength comes from the Atlanta Fed GDPNow model that estimates the U.S. economy will grow at a +5.9% annualized rate this quarter. If this growth is realized, it would mark the fastest growth since the post-COVID recovery and the fifth consecutive quarter of at or above trend growth, highlighting the resiliency of the economy despite tighter monetary policy. The recent strength in the GDPNow model comes from the recent economic reports – the increase from +4.1% just two weeks ago is driven by upside surprises on retail sales, housing starts, and industrial production. Industrial production jumped by a stronger-than expected +1.0% MoM due to robust auto production and demand for cooling/energy. Manufacturing output also rose +0.5% MoM. Finally, the housing market showed continued signs of stabilization. Housing starts and permits rose by +3.9% and +0.1%, respectively, as gains in single-family more than offset declines in multi-family across both measures.
Importantly, +5.9% Q3 growth is not guaranteed. Since Q2 2014 (and excluding the early COVID period), the GDPNow model has overestimated the final GDP print by an average of 0.8% at this point in previous quarters, and by 2.2% when the model suggests +4% or higher. Regardless, strong economic momentum may suggest a recession could be avoided, but that has pushed long-term yields higher.
Looking forward, there are still several risks to the system for 2024 and, unless robust economic activity can be sustained, calls for recession may re-accelerate. The leading economic indicators have been suggesting weakness for over a year. There are several key drivers of this weakness including dampened sentiment and a deeply inverted yield curve, but nearly all other components of the LEI other than stock prices and housing starts are negative. The ten components of US LEI include: average weekly hours in manufacturing, average weekly initial claims for unemployment insurance, manufacturers’ new orders for consumer goods and materials, ISM index of new orders, manufacturers’ new orders for nondefense capital goods excluding aircraft orders, building permits for new private housing units, S&P 500 index of stock prices, leading credit index, interest rate spread (10-year Treasury bonds less federal funds rate), and average consumer expectations for business conditions.
Recession probability still remains elevated using the New York Federal Reserve model that primarily relies on that magnitude of yield curve inversions.
Source: Bloomberg, Federal Reserve, NBER, YCharts