Look Beyond ‘Bellwethers’

Where is the economy headed next? That is a tough question to answer even during “normal” times, and considering supply bottlenecks and the pandemic, the task looks even harder now. It seems to have many experts turning over lots of stones, with some convinced certain economic indicators are bellwethers. But we caution investors against reading too much into any one data series—they all have their limitations, regardless of the economic environment.

Economic bellwethers are supposedly the canary in the coalmine—as they go, so goes the economy. Copper prices are one popular example. Since copper has a wide range of uses, from plumbing to electric cars, many view prices as a proxy for broad economic growth. Rising prices imply demand for goods is purportedly strong. Falling prices suggest the opposite, leading some to believe it shows the economy will soon slow, too. Some think auto sales reflect consumers’ willingness to spend on big-ticket items, so weak sales portend broad weakness. Others zero in on home sales, which they see as a sign of household formation and a key consumption driver. In today’s environment, analysts have explored alternative indicators to divine the economy’s health. For example, some study hospitality hiring trends to determine whether the pandemic’s economic impact is waxing or waning. While the rationale behind some of today’s bellwethers seems logical, we think it is important to dive deeper.

Take the semiconductor industry. A recent Bloomberg article noted that despite the widespread shortage of memory chips, prices have fallen over the past couple months. With several semiconductor companies reporting slowing customer orders and reduced economic outlooks, the concern seems to be that hardware producers see weaker demand for laptops, mobile phones and the like. Since chips feature in a vast array of consumer products, many argue falling chip demand may be a harbinger of a broader slowdown outside the world of gadgets, too.

However, semiconductors aren’t a leading indicator, in our view. Chips are cyclical and behave like commodities. Rising demand lifts prices and incentivizes production, but it takes time for investments to boost output. In semiconductors’ case, new foundries to create chips take years to come online—which puts a lid on supply in the near term.

On the demand side, while some chip producers have noted slowing orders, that doesn’t appear to be an industry-wide development. Those who make cars, video game consoles and smart phones have all reduced production targets due to a scarcity of chips, not flagging consumer demand. Prices of—and demand for—graphics chips, which feature in more high-end and complex electronics, remain firm. Companies who make semiconductor equipment have reported record revenues and expect business to remain strong for the foreseeable future.^[i]

Note, too, falling prices may reflect today’s chip shortages easing to an extent as supply improves. Semiconductor producers have been investing big to increase supply—according to tech-market researcher Gartner Inc., the global semiconductor industry is projected to spend about $146 billion in capital expenditures this year, about 50% higher than 2019’s pre-pandemic spending.^[ii] Some short-term headwinds that hindered production at semiconductor plants this year—e.g., winter storms in Texas and a June fire in Japan—have also passed. Anecdotally, some auto industry executives shared optimism that semiconductor supply is improving, though constraints may persist to varying degrees for a while.^[iii]

Beyond chip prices, some analysts have treated high-frequency data series as bellwethers in today’s economy. Since the pandemic’s onset, many have looked to alternative indicators—e.g., hotel occupancy rates, airline passenger volumes and weekly restaurant bookings—as economic harbingers, especially in the harder-to-measure services sector. As reopening plans progressed, other less-conventional metrics have gained attention, from office occupancy rates to job postings for “close contact” positions (e.g., dental or child-care). Some research outfits and financial publications have even created indexes aggregating real-time statistics to track the economic recovery.

Such datasets were useful for a stretch, in our view, early in 2020. But their utility faded as more folks looked to them. In addition, they have limitations. Quarterly and monthly economic series can be volatile, and weekly and daily reports are subject to even more noise—making it trickier to decipher trends. Many real-time economic stats aren’t seasonally adjusted, even though the time of year could introduce big skew. Consider TSA checkpoint numbers, which would likely be higher during the holidays and other popular travel periods. Moreover, many of these indicators go back only a couple years, and some began in response to the pandemic. That makes it hard to conclude they reveal anything about the economy without at least a full cycle’s worth of history. These snapshots may provide some insight on a narrow topic, but we don’t think they are all-revealing.

Most of these indicators are also backward-looking, which won’t tell you anything about the economy’s direction, let alone stocks. So if you want to check the economy’s temperature, we think it is better to check forward-looking indicators. They don’t directly predict stocks, either, but they do hint at economic drivers over the foreseeable future. To that end, the new orders subcomponent of purchasing managers’ indexes (PMIs) for major developed economies show strong demand, although today’s supply shortages have likely skewed that signal to an extent, sapping its predictive power right now. However, the global yield curve is positively slopped, a positive sign for bank lending, but not too steep that it would enable fast money creation and overheating. The Conference Board’s Leading Economic Indexes (LEI)—which aggregate interest rate spreads, credit data, manufacturing PMI new orders and other data—for the US, eurozone and UK continue rising, suggesting growth is likely in the near future. However, all these indicators have their limits even in a “normal” economic environment. In our view, this reinforces an important lesson for investors: No silver bullet exists in the economic forecasting realm, so beware reading too much into any touted economic bellwether.