Policymakers and investors keep a close eye on the state of the current economy. While the economy is not the same as the stock market, understanding the stages of the economy helps us effectively manage our risk. We've already previously learned that GDP serves as a scorecard or snapshot of the current economic health. Here are some key indicators to the economy:
- New construction
- Manufacturing activity
- Consumer confidence
- New homes purchased
These indicators all help provide an overall view of the economy, and it's best to look at them together rather than on their own. Some give a glimpse into the future, while others tell us about the past or present.
While not exactly like looking into a crystal ball, leading indicators provide signals about the future that we can interpret.
Leading indicators tend to change before the economy does.
In the video, the example of slowing building permits shows less demand and signals a slowdown in the economy. Leading indicators can provide clues about pending trouble and are essential to pay attention to. However, leading indicators aren't perfect predictors of the future. For instance, building permits could have been slow due to bad weather or a lack of supplies from a vendor. Looking at more prominent trends provides a clearer picture without being thrown off by one-off factors.
Building a lot of new homes is a good sign for the economy. It shows that people have the money and confidence in their financial situation to commit to buying a brand new house. The US Commerce department surveys home builders across the country and releases a monthly Housing Start report that summarizes building permits, housing starts, and housing completions data.
Outside of showing demand for new homes, the Housing Start report sheds some light on other industries. Fewer houses being built means fewer construction jobs, negatively impacting those construction businesses and the equipment manufacturers.
It also means fewer mortgages, hurting the banking and financial sector. Lastly, fewer new homes mean fewer new appliances, furniture, and other household goods to fill those homes. We'd expect the revenue for companies making those things to fall as well.
Manufacturing levels can signal what's to be expected for this quarter's GDP calculation. High levels of manufacturing signal economic expansion, and lower levels of manufacturing may signal an economic contraction. Therefore, the Institute for Supply Management (ISM) surveys senior executives at over 400 companies in major industries on new orders, inventory levels, production, supplier deliveries, and employment. The results are published monthly in the Purchasing Manager's Index (PMI) report.
We can see the negative effects of COVID-19 sheltering-in-place and quarantine measures from the US PMI in April 2020.
Confident consumers spend freely without worry and are great for growing the economy. Increased revenue for businesses results in more people being employed, which adds to more spending. When we are not confident in our economic future, we are more likely to save instead of spend. Less spending leads to less revenue for businesses and starts an economic contraction.
The Conference Board polls roughly 5,000 households regarding how optimistic or pessimistic the household members are about their expected financial situation. The results are compiled and reported as a Consumer Confidence Index (CCI). For the US, a CCI above 100 represents strong confidence.
If we look back, all three leading indicators reports pointed toward a significant contraction for April and May of 2020. While this wasn't much of a surprise because of COVID-19, the government responded with policy adjustments to reduce the magnitude of the contraction felt by the economy.
It's always easier to understand something in hindsight. Lagging indicators allow us to understand the effects of an event on the economy after it's already happened. Ideally, we can use that understanding to help make better decisions in the future. Lagging indicators change after the economy changes and confirm what investors and economists suspected from leading indicators.
New home sales
While Housing Start gives us a look at homes being built, we want to confirm that the economic potential of those homes is realized. We need to know if people are actually buying the new homes when they're finished. Here is where New Home Sales is helpful.
The New Home Sales is a monthly report published by the US Census Bureau.
This lagging indicator usually follows the trend in consumer confidence over time. During times of strong economic growth, people feel more secure in their jobs and are more likely to buy large purchases such as homes. Conversely, in times of economic uncertainty or unemployment, consumers prefer to save and forgo expensive purchases. Banks are also more conservative in the availability of mortgages to consumers during an economic recession, driving home sales down further.
Inflation is when the general price level of goods and services in the economy goes up. We know that stuff slowly gets more expensive over time. We measure this movement using an index called the Consumer Price Index (CPI).
The CPI is used to gauge the cost of living and measures the changes in the inflation rate. It's reported by the US Bureau of Labor Statistics monthly.
The CPI follows the cost of consumer goods and services such as transportation, food, and medical care. The Federal Reserve monitors the inflation measurements and unemployment numbers to enact monetary policies. In times of economic expansion, we can expect higher than average inflation or rising CPI, and during an economic contraction, we can expect less purchasing power and a low CPI.
Aside from looking at the past and present, we need to know how things are going right now.
While coincident indicators still take some time for organizations to collect, they help show the economy's current health.
Gross domestic product (GDP) summarizes all the transactions in a quarter that produce goods and services in a country. It's a snapshot of how much stuff the economy is creating. For the US, the BEA (Bureau of Economic Analysis) reports and revises our GDP. The economy expands when we produce more goods and services. On the contrary, creating fewer goods and services is considered an economic contraction.
A strong economy has low unemployment. An economy grows when businesses produce more stuff, and more people buy it. Companies will hire more employees to create more goods and services. At the same time, employing more people means more people have money to buy more stuff.
It isn't a good sign when people are out of work, so the US Bureau of Labor Statistics keeps track of the unemployment rate every month in the Jobs Report. The report surveys households and employers to estimate the number of people employed and unemployed in the economy. Low unemployment, typically below 4%, is an indication of economic expansion. High unemployment, double digits percentages, is an indication of economic contraction. Our central bank, The Federal Reserve, uses unemployment numbers to guide monetary policy decisions.
While these reports come out monthly, pay close attention to the leading and coincident indicators. Lagging indicators are helpful to confirm our economic outlook and provide an opportunity for us to be proactive when we've spotted a trend.
Most financial news outlets report on the leading and coincident indicators. If these indicators start sounding alarms, it might be a good time to consider lowering the amount of risk of your portfolios. Likewise, if you continue to see signs of strong expansion, you might consider taking more risks.