Experts cast doubt on validity of leading indicators

Leading indicators are designed to help predict the robustness of economic activity. A rise in an index is taken to suggest the economy will continue to expand whereas a falling index points to trouble.

Judging by the latest set of composite leading indicators (CLIs) from the Organisation for Economic Cooperation and Development (OECD) the world could be heading for a tough time.

This poses a difficult question for anyone following the global economy. Can an indicator that uses 224 series of data from 29 countries, but still failed to predict the turning point for the biggest crisis in decades, really be useful?

CLIs are composite indicators based largely on data on the early stages of production. The latest set suggests that economic activity within the OECD area, where the CLI fell by 0.1 point in June, is about to drop again.

According to the OECD, an inflection in the CLI curve will generally signal a turning-point in the business cycle in the subsequent six to nine months; the CLIs will move in the same direction as the business cycle.

”We do look at those indicators but they are not the only ones”

In theory, the CLIs “respond rapidly to changes in economic activity”, are “sensitive to expectations of future activity” and are “control variables that measure policy stances”.

However, the OECD concedes that lead times sometimes fall outside this range and turning points are not always correctly identified. The CLIs are also not appropriate for judging the speed or strength of a recovery or downturn.

Perhaps the biggest criticism is that the CLIs failed to predict the turning point for what turned out to be the economic crisis of 2008-09. (article continues below)

The latest CLIs for China, France, India and Italy all point to below trend growth in the coming months, while the CLI for Britain points to a peak in growth.

Stronger signs of a similar peak have also emerged in America, Brazil and Canada. In those three countries, the CLI has turned negative for the first time since February 2009.

The CLIs for Japan and Russia suggest that economic activity is about to slow, while Germany’s CLI remains relatively robust. The construction of those CLIs varies from country to country. They are composed of a set of individually selected economic indicators whose composite, according to the OECD, provides “a robust signal of turning points”.

Britain’s CLI, for example, uses the performance of the non-financial shares index and America’s CLI the New York stock exchange as a whole.

Frances Hudson, a global thematic strategist at Standard Life Investments, says it is a commonly held idea that stockmarkets lead the economy. To a certain degree, she says, this is true but markets have suggested different things.

In contrast, Germany’s CLI does not incorporate stockmarket performance statistics but data from export orders.

“A lot of the indices suggest that economic growth is not as robust as expected,” Hudson says. “While they do not point to a double-dip recession, slower than expected growth for the next couple of years is likely.”

Max King, a portfolio manager in the global asset allocation team at Investec Asset Management, does consider indicators such as the CLI. “We do look at those indicators but they are not the only ones,” he says.

He adds there are other, more reliable indicators than the CLI. The yield curve, for example, has worked consistently as an indicator for many years. When making investment decisions, King and his team also consider factors including market momentum, volatility and price indicators.

Both King and Hudson agree that the CLIs can be useful but are not reliable. Data has only been collected for 12 years and has yet to establish a valid record.

Although the CLIs are often assumed to be good pointers to economic activity they are not accurate enough to be relied upon.