Risk assets have not had a great month so far, with global equities now having eliminated most or all of the gains they recorded during January and February.
It is tempting to view recent setbacks as a natural response to the heightened uncertainty which has been caused by an extraordinary combination of exogenous shocks hitting the system. But these shocks will ultimately cause a bear market only if they are sufficient to cause a major slowdown in global economic activity.
So far, the received wisdom of the macroeconomics-forecasting community is that this will not happen. But the macro-consensus has often been known to be wrong, or very late, at calling turning points. In fact, the markets will usually change direction well ahead of the consensus on GDP.
In order to be any use for market timing, we need to follow data which both impact market sentiment, and which are sensitive to smaller changes in global economic activity. Here are three indicators which are always worth watching carefully.
1. Global Leading Indicators
The OECD leading indicators are by far the most widely-followed series, but they have their disadvantages, notably that they often directly include share prices in the country indicators, and they are published with a two months’ lag. Therefore, I also follow carefully the behaviour of the Goldman Sachs global leading indicator, which was first developed while I was at the firm, and which has been much improved by the outstanding Dominic Wilson. I always examine monthly changes in these indicators, since anything else operates too slowly to be relevant for market timing.
In the graph, I show the most recent monthly changes in these series. They are giving some very slight, early warning signs that the rate of growth in the global economy might be passing its peak — albeit at very high current growth rates, which are substantially above trend. Note that in the OECD series, the global data are slowing, while the data for developed economies are not. This is because the indicators for the Brics are now clearly slowing as policy is tightened, especially in China. This is not happening in the developed economies.
2. Business Surveys
The levels and monthly changes in the PMI data for manufacturing and non-manufacturing sectors are always crucial. Thanks to Markit, these now exist for most economies. If I were to choose one single indicator, it would be the difference between the new orders and inventories series in the manufacturing sector, because this seems to give the best leading information for industrial production in the months ahead, and because industrial production is more important is determining the direction of the cycle than its weight in the economy would suggest.
In the graph, I show this series for the US, with the PMI series shifted forward by three months. It is clear that there is no sign of any peak in US industrial production growth in the coming quarter. The same is true in most parts of the world, but China and the rest of emerging Asia is an important exception. In some Asian economies, PMI data have definitely weakened.
3. US Initial Claims Data
The behaviour of the US labour market has always had a major effect on global market sentiment, because it is taken as a confirmatory signal of the underlying cyclical trend in the world’s largest economy. This is why the non farm payrolls release can have such a large impact on risk assets. Recently, however, the markets have been even more interested in the weekly initial claims numbers, since these give an earlier read on the behaviour of the labour market. Arguably, these have become the key economic data to watch, above all others. As the graph shows, the decline in equity markets which occurred last May-August may have been initially triggered by the European sovereign debt crisis, but importantly it also coincided with a slowdown in the US economy, signalled by the initial claims data. So far, the recent setback in global equities has not been confirmed by any change in the trend on initial claims, which is a hopeful sign.
So what is the answer to the original question?
I suspect that global activity growth has probably peaked for the current mini-cycle, but that is entirely because the growth rate is declining in China and some other emerging Asian economies. (Actually, all of the Brics seems to be slowing.) There has been no sign yet of any peak in the growth rate in the US or continental Europe.
Put all this together, and you have some very good reasons why emerging market equities have been underperforming their developed market counterparts.
More analysis of the economic cycle and global equities appears in this piece from my regular FT blog, here.