Since the beginning of the subprime crisis, capital markets have been particularly volatile. Evidently, the US real estate crisis is not the direct cause of the soaring volatility of recent weeks, but its insidious consequences are now being felt on a global basis due to the structural problems it uncovered – massive piles of debt. In these troubled times, where nothing is certain at all, are there any indicators that can be relied on?
Among the vast range of data and surveys, some leading indicators stand out by their name. Indeed, contrary to many indicators that require lengthy and technical definitions, leading indicators do exactly what they say: they predict the pace of economic activity. They can thus be used to anticipate economic growth – and hence the valuation of assets in a wider context.
Be it equities or bonds, prices reflect growth expectations. Investing can thus be reduced to confronting the market’s reflected pricing with one’s subjective anticipations. For instance, strong growth expectation for a company valued at a discount to this anticipated growth may be seen as a potential buying opportunity.
With this in mind, it is fundamentally rational to seek indicators that can accurately estimate the path of future growth. Although there is, of course, a vast array of potential candidates, most of them share a common methodology. Basically, they are computed by establishing a weighted average of many variables in three main themes: order books, financial and labour market conditions. But in what way can these components be deemed “advanced”?
Meat and potatoes
The first theme (order books) has the clearest predictive power: full order books suggest strong economic performance. In addition to consumer goods and capital goods, the real estate market is also reflected through the inclusion of data for construction starts. The second theme (financial conditions) covers a wider array of variables. For instance, an increase in the money supply is expected to see increased consumer spending – as do the effects of share prices and shifts in the yield curve. This said, these elements only end up influencing consumers’ behaviour. Thus, taking account of consumer sentiment, data is often a key component of leading indicators.
Similarly, the situation in the third theme (labour market) can also be considered as a determining factor for consumer spending patterns. In addition, the size of the workforce and the number of hours worked give some guide as to production capacity. So what are these leading indicators telling us now? Having risen steadily since October 2011, the Conference Board index in the US saw only a very slight decline in April. Of the ten variables included in the index, less than half were in negative territory. In the meantime, the world’s main stock markets plummeted.
Extrapolating the link between the economy and the financial sphere, it is tempting to try to anticipate that market behaviour will follow the index data. However, a simple statistical analysis shows that the index has only limited predictive power for this purpose. Does this suggest that the weighting of the resulting index is not optimal? It is more likely that changes in the prices of assets cannot be explained solely by the variables included in the composite index. In the case of the current crisis, systemic risk linked to pressure on certain areas of the sovereign debt markets is only indirectly reflected in the underlying variables used in the index.
The only paddle
So what is the point of this type of information? Adrift in the middle of the ocean, are you going to set aside your navigational instruments because they cannot predict rogue waves? It is clear that the tools we have at our disposal will not enable us to avoid every storm. Neither the real economy nor the financial sphere are immune to unforeseeable shocks. Although using the information available to us does not mean we will be able to predict the future precisely, failing to use it could mean that we overlook some worrying signs. Although the first signs of the subprime crisis were given by statistics for the real estate market, it was impossible to estimate the scale of the crisis without carrying out a global analysis of leverage effects. These extended well beyond the US housing market to affect the entire global financial system.
Without a doubt, the advantages of an indicator derive from its transparency. In order to assess its usefulness in a given situation, it is essential to understand what causes its fluctuations. It is only through this explanation that we can understand the repercussions that may go well beyond the variables used to create the indicator. In the current climate, the biggest risk comes from a factor that is not directly quantified by the variables discussed earlier. The spectre of weak government finances in some European countries coming under extreme pressure continues to argue for a moderate exposure to risk-bearing assets.
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Article by Yann Schorderet
The author is quantitative strategist at Mirabaud & Cie, banquiers privés