(LEI) Leading Economic Index

 

Report card

One expectation we had, which doesn't fit neatly in any of the four categories, was that concerns about government debt would become a larger part of the 2023 conversation. Sadly, we were right about that, even with the recent deal to avoid a debt default.

With regard to the Fed, inflation, the economy, and labor market, what we expected has largely panned out. Inflation has continued to trend down, the Fed is not poised to pivot to rate cuts any time soon, leading economic indicators have weakened further, more cracks have appeared within labor market data, and the concept of a "rolling recession" continues to define economic activity. 

In terms of the stock market, we believed the first half could bring some rougher sledding if the economy weakened notably, giving way to a sunnier second half. Along with that, we anticipated that last year's outperformance by equal-weighted indexes relative to cap-weighted indexes would likely persist. We missed the boat to some degree on that. As will be detailed below, cap-weighted indexes like the S&P 500 and Nasdaq have had a strong first half, driven by a concentration of performance among a small handful of mega-cap stocks.

That said, performance under the surface has indeed been more connected to the macro uncertainties that persist. In addition, as we expected, quality-oriented factors (like strong free cash flow, healthy balance sheets, positive earnings trends) continue to perform well, which has likely been aided by large-cap outperformance this year.

We also expected that the compression in profit margins and the rolling nature of earnings deterioration among sectors would persist. In addition, stabilization in either ISM surveys or housing could help stabilize earnings. We have started to see improvement among a number of housing indicators, but the recent downtick in the ISM non-manufacturing survey suggests we haven't hit the stabilization point yet.

What say you, Fed?

We are a bit handicapped with regard to the Fed policy outlook given the publishing of this commentary is two days before the June Federal Open Market Committee (FOMC) meeting. As of this writing, the market is anticipating a pause in the Fed's rate hiking cycle, with the FOMC leaving the door open for at least another rate hike.

Perhaps more important is our view that regardless of whether the "terminal rate" (the stopping point by the Fed) is one or two hikes from the current level, we do believe the Fed will not be pivoting to rate cuts this year—absent a significant contraction in the economy and/or more serious turmoil in the banking system. Importantly, if inflation continues to trend lower—and the Fed keeps rates elevated—a pause could be seen as a tightening given that nominal rates would remain steady, but real rates (nominal minus inflation) would rise.

Lower leading indicators

A frequent feature of our work is the Leading Economic Index (LEI) from The Conference Board, not least because of its solid track record in leading the economy (both at tops and bottoms) and depth and breadth of its 10 components. Regular readers know we've been pointing out weakness in the LEI for quite some time. As shown below, its decline from the peak (reached 16 months ago) has extended to nearly -10%, which is consistent only with prior recessions.