Summary

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  • For investors, an assessment of the prevailing economic environment is a critical component in determining the risk characteristics of asset classes. For example, a bullish economic backdrop may support riskier asset classes such as equities or corporate debt, whose performance hinges upon the health of the overall economy
  • Indeed, there has been an impressive acceleration in global economic activity since the summer of 2016. However, this has been concentrated in sentiment indicators and surveys (so-called “soft” data), whilst releases of activity indicators (“hard” data) have been relatively disappointing. This raises questions over whether the improvement reflects excessive optimism rather than a “real” cyclical upswing
  • The gap between “hard” and “soft” data manifests itself in our Nowcast of underlying US economic activity, with a lower rate of activity registered in April when “soft” data is excluded
  • Economic surveys are an imperfect tool, relying on imprecise measures of activity based on a sample of respondents. However, they benefit from timeliness, whilst there is evidence that they lead business cycles. Survey data can also fill the gap in sectors with limited “hard” data
  • Importantly, our Nowcast model assigns the largest weight to data points that have the most relevant bearing on economic growth. Therefore, unless the relationship between “soft” data and underlying growth has structurally altered, the Nowcast should still provide a reliable signal of real economic activity. Overall, this provides us with an unbiased tool to aid us in important asset allocation decisions


This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination.

Introduction

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The prevailing economic environment is an important component of asset class performance. When the economy is performing well, riskier asset classes such as equities and corporate debt tend to benefit, whereas a gloomier backdrop usually supports perceived “safehaven” assets such as government bonds. For investors, therefore, an assessment of the current economic environment is a critical component in determining the risk characteristics of asset classes, helping to aid important asset allocation decisions.

Indeed, data releases have shown an impressive acceleration in global economic activity since the summer of 2016. However, this has been concentrated in sentiment indicators and surveys (so-called “soft” data), whilst releases of activity indicators (“hard” data) have been relatively disappointing. This is represented in Figure 1, which shows the gap between actual data releases and what was expected prior ie the degree of “surprise”. This raises questions over whether the improvement reflects excessive optimism rather than a “real” cyclical upswing.


The gap between hard and soft data is reflected in our Nowcasts

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The gap between “hard” and “soft” data is visible in our Nowcast (ie current estimate) of underlying US economic activity. By excluding sentiment indicators and surveys from the model, the rate of activity during April was 1.4 per cent versus 2.7 per cent in the full specification version (Figure 2).

Indeed, over the last six months, surveys have contributed about 50 per cent to our US Nowcast signal, a much larger share than normal. In the eurozone, the April Nowcast result was also weaker without surveys by a similar magnitude, at 1.5 per cent instead of 2.5 per cent.

Surveys have their drawbacks…

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Surveys are an imperfect tool. They rely on a sample of respondents to give their opinion on the state of the economy, rather than providing a “hard” measure of activity.

Indeed, many surveys are “diffusion” based, asking whether activity has “expanded”, “contracted” or remained “unchanged” over the month. The more respondents citing expansion, the higher the final number. This is fairly imprecise as it does not indicate by how much activity has expanded. For example, 10 respondents reporting a moderate uptick would yield a better result than eight respondents observing a strong expansion.

…although are an important signal

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However, surveys also have many advantages. Namely, they possess: (i) forward-looking properties (ii) timeliness and (iii) a wide coverage of economic areas.

First, surveys have been shown to lead business cycles and therefore play an important role in Leading Economic Indicator (LEI) analysis. For example, the ISM index of New Orders and average consumer expectations for business conditions are part of the Conference Board LEI. Furthermore, looking back at times when “soft” and “hard” data diverge, “soft” data is usually a good predictor of the “hard” data going forward.

Second, “soft” data releases are relatively timely versus “hard” activity indicators, useful for analysts who want to track the economic cycle in “real-time”. For instance, industrial production data is typically released three weeks after the end of the reference month, whilst we receive several surveys just two weeks into the month. For some data (eg German industrial production) the delay is even longer (seven weeks).

Third, there are limited “hard” activity indicators covering the services sector (only retail sales in most cases). This is despite the fact that the service sector accounts for the major share of output in advanced economies (eg 70 per cent of US GDP). Surveys can fill this gap. As a result, including survey data for the service sector generally improves the model fit for advanced economies.

Economists are fickle

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Furthermore, the current debate reveals individual biases, by which emphasis is placed on data releases that are preferred, or suit a particular narrative. For instance, after the UK voted to leave the EU in June 2016, national sentiment indicators rapidly deteriorated with many analysts certain that “hard” activity prints would follow suit. We now face the opposite situation, with question marks over upbeat sentiment prints and proclamations that only “hard” data is worthwhile. We need to avoid these biases.

Our Nowcast is developed to strip out bias

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A signal approach is appropriate to deal with “noise” inherent in economic data and crucial in helping us to understand where we are in the cycle.

Fortunately, our Nowcast model is constructed to assign the largest weight to the data points that have the most relevant bearing on economic growth. Therefore, unless the relationship between “soft” data and underlying growth has structurally altered, the Nowcast should still provide a reliable signal of real activity in the economy.

Ultimately, this enables us to assess the economic environment in an objective, bias-free way – a crucial component in developing optimal investment strategies.

Disclaimer

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