Recession Probability model & Leading Indicators – A Holistic Perspective

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Whilst history doesn't repeat itself, it often rhymes, so the saying goes. In this sense, every economic cycle is unique however various underlying patterns repeat themselves with a high degree of consistency. With an understanding of the underlying economic patterns and the reasons these patterns occur, we can analyze the data to ascertain where we are in the current economic cycle, at any point in time, with a reasonable degree of confidence.

How To Use Economic Cycle In Investment Strategy

An understanding of where we are in the current economic cycle adds a lot of value to investment strategies.
For a simple investment strategy consisting of stocks or cash, one can assess how heavily to be invested. An investor may want to more confidently time their entry to the stock market by investing in the earliest stages of the economic recovery, and hold a fully invested position through the economic expansion, before likely looking to progressively move back to cash when late cycle conditions arise and significantly back to cash when recession risks are high.
This is more advanced than traditional market timing methodologies which propose one should invest more heavily when markets are cheap, versus when markets are expensive. Whilst the valuation-based strategy makes sense in theory, it is heavily flawed by the fact that market valuations have not been consistent over time, and markets can remain expensive for very long periods of time leaving an investor sitting on the sidelines. It is also, in our opinion, that this strategy fails to build investor conviction in their investment decisions and is more useful as a reference input into decision making, rather than a tool by itself. We do consider this below.
A more advanced investment strategy may be similar to above, but involve the addition of further financial instruments. For example, in the early stages of the economic recovery, an investor may wish to add leverage to their investment portfolio, and gradually reduce this leverage as the economic expansion matures, before finally acquiring put options or shorting ETFs as a market portfolio insurance strategy as the indications of late cycle economic characteristics arise and risk of recession increases.
Finally, a more complex strategy may wish to rotate portfolio exposure depending on the stage of the economic cycle we are in. For example, in the earliest phases of an economic recovery, cyclical sectors tend to perform the best (i.e., consumer discretionary, building materials & construction), where as in the late cycle, more defensive sectors (i.e., healthcare, utilities & telecom) begin to outperform due to their more stable top-line characteristics whilst sectors that are responsive to building inflationary pressures (i.e., commodities) also tend to perform well. Finally, in the recession stages, those sectors with the most defensive characteristics perform the best. Alternatively, investors ....

Utilising Economic Leading Indicators

The value of utilising multiple tools to make a holistic assessment of current economic risks can be deepened further by the additional utilisation of liquidity based Economic Leading Indicators.
Leading indicators are designed to give insight into the future direction of risk asset prices (i.e., stock market). To be useful, they must firstly make logical sense, and secondly have proven a degree of reliability, historically.
Our top two tools are centered around the teachings of the famous macro hedge fund manager, Stanley Druckenmiller, who was one of the first to define a now widely held belief that whilst earnings move individual stocks, liquidity moves markets.
At a macro level "liquidity" is the availability & cost of money and credit, which drives business capital investment decisions, jobs, consumption, and as a result the direction of the economy and markets. Central banks are often central to setting the cost & availability of money & credit, and it is here our economic lead indicators focus: central bank policy & money growth. It can be seen in the charts below that the changing direction of the Fed Funds rate and money growth (M2) tends to lead movements in economic strength, as measured by the Purchasing Managers Index (PMI). Note that we focus on the PMI as it is a real-time indicator of economic strength, and thus moves in coincident fashion with the stock market.


These tools are certainly not perfect leading indicators (if they were, we probably would not share them). There is no such thing. However, consider the logic, for example of why the Central Bank rate leads the PMI. As central bank rates fall:
• The cost of interest falls and those consumers who don't have fixed rate debt benefit from increased discretionary income;
• Home buyers now have more affordable access to new mortgages, increasing demand for housing. This kickstarts the construction, renovation & home furnishings cycle;
• Businesses can now access debt for investment purposes at more competitive rates, encouraging new investment plans & driving new jobs in the economy.
Evidently, there is a time lag between when the rates are initially cut, or hiked, and the flow on effect through the rest of the economy. This is not to say, however, that the PMI cannot continue to accelerate in spite of aggressively hiking Central Bank rates. If economic strength is powerful enough, then it may take time before the Central Bank rate hikes puts pressure on and weakens the economy. This is why no one individual tool should be overemphasized, and instead, a range of proven & powerful tools should be followed by the investor, with the aim to keep an eye on the holistic view of what the tools are saying.

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