Every week, new information about the state of the economy is released. It’s easy to be misled by the noise, and to miss the signal, because time series fluctuate around their underlying trend, and because different time series give different signals in the short term. This is especially the case when the media and the markets fixate upon yesterday’s statistic, not the trend—down half a per cent last month after being up 2% the month before is a different picture from being down half a per cent last month after a fall in the previous month too.
One way around this is to create composite indices. These combine many different time series into one series, which in principle (for various statistical reasons I won’t elaborate) will have lower volatility (or variability) than a single series. This is the same principle behind portfolio diversification, i.e., holding a spread of different companies in a portfolio, instead of just one or two.
You can specially select time series for your composite index which tend to turn up or down before the economy does. This is the basis for “leading indices” calculated in many countries. In the same way, you can also calculate “coinciding indices” which try to track the current state of the economy. In both cases, combining many different data sources into one gives you greater clarity and a clearer insight into what is actually happening or going to happen.
SIRA Group’s Australian leading index contains 12 component time series. Our coinciding index contains 7 component series. The chart below shows the year-on-year change in both these indices with shaded areas representing periods when Australia was in recession.
The red line represents the year-on-year change in our leading index; the blue line the year-on-year change in our coinciding index. The leading index “leads” by about 6 months. The lead isn’t the same each cycle. For example, after the GFC, because consumer and business confidence was so fragile, and because consumers were trying to improve their own balance sheets by paying down debt, the lag was longer, and despite the mining boom, the economy has been weaker than usual.
The key observation to make now is that our index (as measured by the year-on-year change shown in the chart) has turned down. In fact it’s been falling on a year-on-year percentage change basis since November last year, and in absolute terms for the last 3 months. This may be just a short term hiccup, or it may be something more serious.
The RBA’s own forecasts suggest that growth will be sluggish and unemployment will trend up, which we would agree with.
Will this affect the share market? Probably not the overall market, because a sluggish economy also means interest rates won’t go up and the A$ might go down, which would be good for shares overall, but certainly individual companies will likely struggle. Stock selection will be even more important than usual over the next few months.
