The Conference Board today released their monthly Leading Economic Indicator index for February. Overall the monthly report was very positive driven primarily, but not entirely, by continued boosts from areas directly affected by government intervention – interest rates and financial markets. However, in the other two top spots were also the increases in building permits and the drop in jobless claims. The latter two, as we discussed several times in the past, have been skewed by the unseasonably warm weather.
In regards to the last point David Rosenberg summed it up the best: “This is the warmest winter in 65 years and with the least amount of snowfall as well.” This means that more people were able to get to work, construction continued, etc. all contributing to the gains that have been seen so far. More importantly, however, is the effect of this warmer weather on the formulas that create the seasonal adjustments. Those formulas can magnify relatively small skews in the underlying raw data. For example, as David pointed out, if the February seasonal adjustment were applied to January to account for the weather shift, and March’s applied to February, instead of a 511,000 job increase in the first two months of the year there would have actually been a decline. This “weather anomaly” is not only skewing the data in the employment data but in all data that is seasonally adjusted. In turn all of the indices that rely on those seasonally adjusted data points, like the LEI, are also skewed.
One way to strip out some of this anomalies is to view the data on a year-over-year basis. If we look at LEI on this basis we find that growth rate of the LEI has slowed dramatically. After LEI peaked in April of 2010, as the first round of QE was coming to an end, it has been on a steady decline even with the recent signs of economic improvement. One observation, and as we have discussed many times previously, is that the subsequent rounds of QE in 2010 and “Operation Twist” in 2011 – while fueling the stock market – have had diminished effects on the overall economy. More importantly, the current decline in the year-over-year growth rate of the LEI has always tracked very closely to the ebb and flow of the “real” economy.
The current economic improvement that we are seeing has certainly been welcome. However, while the LEI is not indicating a recession currently, the slope and magnitude of the decline are definitely cause for concern about pending economic weakness. The reason is that, outside of the seasonal effects, the economy got a boost in demand post the Japanese earthquake last March. That shut down in production, combined with the debt ceiling debacle during the summer, created a vacuum in the manufacturing sector and a bleed down in inventories. This fulfillment of pent up demand and inventory restocking has now likely run its course.
This was reflected in post-earnings conference call by Federal Express (FDX) this morning where the company stated it would reduce flight hours, park some planes due to weakness in technology, mobile phones, finance, insurance and real estate. This led to their view that the economy would be seeing below trend growth. For a company that provides a base service to every industry in the company this certainly isn’t a view that would support the mainstream media’s outlook for continued economic growth.
We can find further confirmation of weakness in the overall economy if we look at the ratio between the Conference Board’s coincident and lagging indicators. This acts like a book-to-bill ratio for GDP. Currently, it is off of its peak by about 2% and at levels that have normally coincided with recessions in the economy.
While the current month to month data points are still indicative of growth – the concern is strength of that growth. With the underlying economy fragile and very susceptible to external shocks it will not take much to create a retrenchment. If this was truly not the case the Fed would not be holding the line at zero interest rates and floating hopes of continued asset purchases (QE) in the future. Now with China slowing more rapidly than expected and Europe continuing to slide – the ability for the U.S. to withstand that drag indefinitely is negligible. As the seasonal weather patterns return to normal ranges, along with the data skews, we will get a much better picture about where the economy currently stands. My bet is that the mainstream media is going to “unexpectedly” disappointed. Invest accordingly.