Chicago Fed National Activity watch – the best widely ignored index – paints grim US economic picture
US economic growth is likely to disappoint market expectations this year -– a game-changer for consensus allocation strategies – if the little-known Chicago Fed's National Activity Index is anything to by. This risk is further underscored by the surprise fall in US manufacturing in May, according to Monday’s ISM report.
Even with the recent decoupling of stock market highs and manufacturing lows, asset markets, investors like to think, are structurally sensitive to macroeconomic data on a directional, not just intra-day, basis.
Amid fears of market bubbles, hopes are growing rising markets will correlate more strongly with improving US economic data in the coming months. In sum, price-sensitive investors hope capitulation trades – bears surrendering amid fear of underperforming the benchmark – will be justified on the back of brightening US growth prospects, prompting the Fed to taper its bond-buying programme.
That’s the backdrop at least to the sell-off in US treasuries. But could this prove a false dawn? On Monday morning, markets received a sobering reminder that the case for the US upturn is not cast in stone, after the Institute for Supply Management recorded a surprise fall in its US factory index to 49.0 in May, from 50.7 in April, with a sub-50 reading indicative of a contraction.
But there is one reason why that should not have come as a surprise. In a blog published on Friday, Russ Koesterich, the iShares global chief investment strategist at BlackRock, notes the remarkable forecasting power of the Chicago Fed National Activity Index (CFNAI), a weighed average of 85 existing monthly indicators of US economic activity.
The Chicago Fed describes the methodology thus: “It is constructed to have an average value of zero and a standard deviation of one. Since economic activity tends toward trend growth rate over time, a positive index reading corresponds to growth above trend and a negative index reading corresponds to growth below trend."
The indicator has been negative for the past few month and plunged to -0.52 for April. Koesterich – strategist at the world’s largest investor – thinks this should be a big cause of concern.
“Unlike backward-looking statistics like GDP, the CFNAI is a forward-looking metric that gives some indication of how the economy is likely to look in the coming months.
“And of all the indicators I’ve tested, the CFNAI has the best track record of forecasting future GDP. Since 1980 the CFNAI has explained roughly 40% of the variation in the following quarter’s GDP, an extremely high proportion for a single indicator.”
He adds: “If recent CFNAI readings are any indication, investors may want to alter their growth assumptions for the third and fourth quarters,” equating to 1.8% in the second and third quarter of the year.
Koesterich concludes: “To be sure, as the chart above shows, the three-month moving average indicator has remained around zero for most of the past three years. In other words, the CFNAI isn’t predicting a recession, but it is forecasting a continuation of the same slow-growth environment we’ve been in since mid-2009.” In recent years, the litany of mixed economic signals as well as revisions to US economic forecasts and recorded output has vexed investors, increasing the popularity of dynamic and ostensibly forward-looking macroeconomic indicators, including the Citi Economic Surprise Indicator, HSBC’s PMI index and JPMorgan Asset Management’s Deflation Alert Indicator.
If the BlackRock strategist is right, after looking at banks’ proprietary models, US GDP figures, monthly non-farm payrolls or ISM data, the CFNAI could be another one to watch – and one that should boost the UST bulls and equity bears.