Cyclical Shift in Sight

Executive Summary

• There's a cyclical shift in sight.
• Shorter leading indicators have started to peak.
• Coincident indicators are still rising.
• The probability of a downturn in economic growth is rising.

Cyclical Shift in Sight

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The probability of an economic inflection point is rising based on leading economic indicators.

An inflection point in economic growth requires a change in asset allocation. 

When studying economic trends, we most often separate the analysis by time frame. Cyclical economic trends, the focus of this monthly report, last several quarters on average. Most often, cyclical economic trends fall into the 6-18 month time frame. 

Cyclical economic trends or "growth rate cycles" are defined by "coincident economic data." Coincident economic data is the target, comprised of the broadest and most accurate indicator of real growth from each corner of the economy.

For example, industrial production picks up the manufacturing sector. Nonfarm payrolls provide a read on employment. Adjusted real income measures real personal income after taxes, and excluding government transfer payments. Government transfer payments are captured in real consumption, the last of the big four coincident indicators.

Leading economic indicators provide advanced warning ahead of major cyclical turning points in coincident data. Decades ago, economic cycle analysts started to separate leading indicators into two baskets based on their average lead time ahead of inflection points in coincident data.

Longer leading indicators can pivot up to 12 months ahead of coincident data, while shorter leading data holds an average lead time in the range of 2-6 months.

Leading indicators generally have longer lead times ahead of economic downturns and shorter lead times ahead of economic upturns.

In the sections that follow, let's review several indicators from the long leading indicator basket, the short leading indicator basket, and coincident economic data so that we can determine the impact on asset prices. 

After analyzing these data groups, you'll see why the probability of an economic downturn is increasing, but also why it remains premature to fully shift to an overweight stance on defensive assets.

The data provides confidence that the best of this economic cycle upturn is in the rearview mirror, and it is time to start shifting asset allocation exposures back towards a baseline or benchmark exposure.

If leading indicators continue to move lower and a new economic downturn is fully confirmed, the investment outlook will continue moving from overweight cyclical assets to a balanced or neutral stance and then to a fully defensive outlook.

Let's take a look.

Shorter Leading Data

Shorter leading data has started to move off peak rates of growth but has not moved below trend like longer leading data.

Real consumer durable goods new orders posted a peak rate of growth in October 2020 and are nearly below trend. Core capital goods new orders, also deflated to account for inflation, had a peak rate of growth in December of 2020.

Real Consumer Goods New Orders & Real Core Capital Goods New Orders:

Source: Census Bureau, YCharts

The price growth for raw industrial commodities has not made a new high since April. The price growth in the ratio of industrial metals to gold similarly peaked in April.

CRB Raw Industrials & CRB Metals to Gold:

Source: CRB

Across the basket of more than a dozen shorter leading indicators, so far, none are below trend despite many moving off peak rates of growth. This sequence between longer leading data and shorter leading data is consistent throughout history.

Only once shorter leading data is in a clear downturn should we start to expect a meaningful slowdown in coincident economic data, which is the target.

Coincident Economic Data

Coincident economic data defines the growth rate cycle and the business cycle (recessions). Consequently, market narratives are highly influenced by coincident growth data and coincident inflation data.

While we have seen a peak and decline for longer leading data, a potential peak, and a decline for shorter leading data, we have not seen a defined peak nor move below trend for the main coincident economic data.

As you recall, coincident economic data represent the key areas of the economy, including production, income, sales, and consumption.

Real consumption growth and adjusted real income growth are at or near new highs. 

Coincident Economic Data:

Source: BEA

The growth rate for both industrial production and nonfarm payrolls are hovering near cycle highs.

All main coincident data is above trend, consistent with the long leading, short leading, coincident sequence outlined earlier.

Coincident Economic Data:

Source: BLS, Federal Reserve

Timely shifts in asset allocation do not wait for a full peak and move below trend in coincident data. By that point, asset markets will likely have accounted for this cyclical shift.

Lead times vary from cycle to cycle, but an ideal asset allocation pivot comes after a confirmed trend change in longer leading data and shorter leading data but before a trend change in coincident economic data.

While coincident economic data is still moving higher with peak rates of growth, the longer leading and shorter leading data are flashing yellow lights that a peak in growth is near.

Without a confirmed downtrend in any shorter leading data yet, it is premature to hold a defensive cyclical view. However, we have an increasing amount of confidence that the best part of this cyclical upturn is in the rearview mirror, and asset allocators should start the process of moving portfolio exposures back towards a baseline stance compared to a heavy cyclical overweight stance.

Summary

Longer leading economic data has broadly peaked and has moved below trend. Shorter leading data appears to be in a topping process, but none of the shorter leading data is below trend.

Coincident economic growth is still near the cyclical peak, and thus the shift to a heavy defensive posture remains premature.

When cyclical growth and inflation trends are moving higher, stocks and commodities hold the trending outperforming. As cyclical trends shift and downtrends are confirmed, bonds and gold will start to gain the performance edge over equities and commodities.

The evidence of a summer slowdown is mounting, and it is prudent to dial back cyclical exposure in favor of a more balanced or baseline allocation of risk.

The next 6-8 weeks of economic data will be critical to determine the upcoming economic trend. The next [Cyclical Update] report will be published on July 7th. 

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* This was a shortened version of the EPB Cyclical Leading Indicators report, published monthly. 

If you are looking for monthly updates on the short-term cyclical trends in the economy so that you can stay ahead of major asset rotations, then I invite you to subscribe for only $12.99/mo. 

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