This Little-Known Fed Index May Be Signaling Recession

By: David Sterman Street Authority

Over the past year, economists have noticed an unusual pattern as they digested the series of monthly reports on housing, consumer confidence, purchasing managers, trade flows and other key economic inputs.

These reports showed consistently mixed signals, though it was clear that the U.S. economy was faring OK. And that has led to hopes of more consistently positive reports in the second half of 2013 and into 2014. By next year, many economists have come to expect a firmer backdrop, with GDP perhaps growing in the 2.5% to 3% range.

Yet it may be time to start questioning that brightening outlook. Perhaps the greatest measure of economic activity -- one ignored by most investors, unfortunately -- is flashing yellow and may soon be flashing red

85 Inputs
While many economic surveys aim to capture a slice of the U.S. economy, the Chicago Fed's National Activity Index (CFNAI) looks at 85 different economic inputs focused on production, income, employment, personal consumption and housing. A quick snapshot of the most recent reading actually shows a slight improvement from the previous month.

Yet economists at the Chicago Fed emphasize the importance of looking at longer-term trends rather than monthly snapshots. That's why they suggest that the three-month moving average of these reports is where you should focus -- and by that score, the CFNAI is in trouble.

CFNAI 3-Month Moving Average

Source: Federal Reserve Bank of Chicago

Though the CFNAI began the year in positive territory, it has recently slipped below negative 0.40. Note that the Chicago Fed believes that a reading of negative 0.70 signals entry into a recession, and we still have a ways to go before that happens.

In addition, the current slide could prove short-lived. After all, this index slid to negative 0.49 in October 2012 and then rebounded. Back then, the economy was looking tenuous as businesses and consumers were frozen by fears of a possible government shutdown (which never came to pass).

This time around, gauges of consumer activity appear to be holding their own, but several business gauges -- such as the purchasing managers' index, sales trends and inventory changes highlight a slowly weakening business sector.

The question is whether the ongoing challenges in Europe, the incipient slump in China, Brazil and elsewhere, and the impact of our own sequester will lead to further weakness in the business sector. This is an issue that you should be closely monitoring if you remain fully invested in the stock market, especially if you're holding economically sensitive stocks.

Later this week, a number of Federal Reserve members will be weighing in on the economy, including:

  • Minneapolis Fed President Narayana Kocherlakota, speaking on Wednesday in Seoul
  • Fed Governor Jerome Powell speaking on Thursday at the Bipartisan Policy Center
  • Atlanta Fed President Dennis Lockhart speaking on Thursday in Atlanta
  • On Friday, three more Fed presidents -- Jeffrey Lacker, Sandra Pianalto and John C. Williams -- will speak about the economy at various public forums.
  • Interested investors should track these economists this week, as they may shed more light on what appears to be a slowing U.S. economy.

Earnings Season Commentary
Of course these Fed governors and presidents will be weighing in just as many companies are finishing up their second quarter and preparing to give their outlooks for the remainder of 2013. At this point, it's hard to see how the coming earnings season commentary will be optimistic. To be sure, expectations going into each of the past few earnings seasons have been dim, and companies have delivered guidance that was not nearly as dire some had feared.

My biggest concern: The sharp recent weakening in many currencies could lead U.S. multinational firms to trim expectations as foreign sales are denominated back into dollars. On a related note, how will recent turmoil that has emerged in China (banking liquidity), Turkey and Brazil (social unrest), and Greece and Italy (spiking bond yields) affect company outlooks?

Risks to Consider: As an upside risk, the CFNAI could rebound as we move past the effects of the recent government sequester.

Action to Take -- Although the Chicago Fed's National Activity Index dipped to similarly concerning levels in October before rebounding, you shouldn't dismiss this current reading. Prior to October, the last time this reading was less than negative 0.49 was back in 2008 and 2009, when the economy was on extremely tenuous ground. Though it's unlikely that we'll see as sharp an economic slump as we did back then, it's becoming harder to rule out at least a mild recession in coming quarters -- which is food for thought with the major market averages still near all-time highs.

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3 thoughts on “This Little-Known Fed Index May Be Signaling Recession

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  2. "though it was clear that the U.S. economy was faring OK."

    Hmm, lets see, GDP growth is under 2% after 7% federal deficit spending and another $85B a month from the Fed. Looks like we have a new definition for "faring OK".

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