Two types of dispersion are increasingly apparent in market dynamics here. The first type of dispersion is between leading measures of economic activity and lagging ones. The second is dispersion in market internals, particularly observable in a continued narrowing of leadership to a handful of “winner-take-all” stocks, while broader measures of market action across individual stocks, industries, sectors, and credit spreads show persistent divergence that suggests increasing risk-aversion among investors.
As I’ve frequently noted, if one examines the correlation profiles of various economic indicators with subsequent economic activity, there is a clear sequence. The earliest indications of an oncoming economic shift are observable in the financial markets, particularly in changes in the uniformity or divergence of broad market internals, and widening or narrowing of credit spreads between debt securities of varying creditworthiness. The next indication comes from measures of what I’ve called “order surplus”: new orders, plus backlogs, minus inventories. When orders and backlogs are falling while inventories are rising, a slowdown in production typically follows. If an economic downturn is broad, “coincident” measures of supply and demand, such as industrial production and real retail sales, then slow at about the same time. Real income slows shortly thereafter. The last to move are employment indicators — starting with initial claims for unemployment, next payroll job growth, and finally, the duration of unemployment.
What we observe at present is something of a race. The most lagging and backward-looking measures of the economy continue to show the most strength; precisely because they indicate what is in the past rather than what is in the future. Unemployment duration continues to fall, payroll growth has enjoyed a recent upward surprise, and initial claims for unemployment — though flattening out — remain near multi-year lows. Largely on the basis of improvements on the employment front, the Fed is quite eager to move away from zero interest rate policy by hiking the Federal funds rate in December (by paying banks a fraction of a percent more on idle excess reserves) — a move that is now broadly anticipated on Wall Street.
Meanwhile, the most leading and forward looking measures of the economy continue to deteriorate. The race, in this context, is whether the economic weakness that’s already evident in the leading measures actually becomes reflected in the employment numbers soon enough to derail a rate hike. The chart below updates our measure of “order surplus” based on standardized values of regional Fed and purchasing managers surveys. My impression is that this chart presents a good representation of the actual state of the economy here — deteriorating enough to create a clear risk of recession, but not profoundly enough to establish a confident expectation of recession.
