The Federal Reserve is actively trying to curb demand in the economy by raising rates, and all the talk is about whether they can usher a ‘soft-landing’ without triggering a deep recession. So, the Fed will be a key factor to watch in the second half of the year. But I also have three other economic fundamentals investors should put on their watchlists, as they could be key in determining the path of the economy and markets over the next year.
Economic Fundamental #1: The Yield Curve
As a quick refresher, the yield curve represents the difference between long-term and short-term interest rates, which also serves as a proxy for loan profitability for banks. Since banks borrow at short-duration rates and lend at long-term rates (generally speaking), a steep yield curve creates higher net interest margins, which usually results in more credit, loans, and economic activity. On the flip side, an inverted yield curve signals it is more expensive to borrow money short-term than long-term, which means something is likely awry in the credit markets.
Historically, the yield curve has been a good forward-looking indicator for the economy, which is why rapidly rising short-duration U.S. Treasury bond yields are worth watching closely. In the chart below, the yield curve is presented as the 10-year U.S. Treasury bond yield minus the 3-month U.S. Treasury bond yield – the preferred measure. A declining line means the yield curve is flattening, and if the line falls below 0%, it means the yield curve is inverted. As seen below, the yield curve is clearly in a flattening pattern and close to inverting, making it a key indicator to watch in 2022.
Source: Federal Reserve Bank of St. Louis1
An inverted yield curve signals credit markets could come under strain, but it is not an immediate indicator of recession and/or bear market. There is usually time for investors to act.
Economic Fundamental #2: Leading Economic Indicators
The Conference Board Leading Economic Index is a pretty solid indicator for future economic activity. Because the index measures leading indicators like New Orders, Building Permits, Jobless Claims, Credit Spreads, and the stock market, it offers a comprehensive picture of expectations for future economic activity. A high and rising LEI almost always signals economic expansion ahead.2
In June, however, the LEI fell by 0.8% to an index reading of 117.1, which is still quite high relative to the years leading up to the pandemic but also marks four months of consecutive decline. In the first half of the year, the LEI fell 1.8%, which was a reversal from the 3.3% growth posted in the second half of 2021. Whether or not the LEI recovers or continues to decline in the second half will be a key indicator to watch in the second half, and could offer the clearest clue of a possible recession later in 2022 or early 2023.
Economic Fundamental #3: Earnings
Finally, there is the ever-important economic fundamental of corporate earnings, which are the single biggest driver of stock market returns, in my view. With roughly half of S&P 500 companies reporting, total earnings are up +1.4% from the same period last year on +11% higher revenues, with 75.5% beating EPS estimates and 65.7% beating revenue estimates. This is a slightly lower beats percentage than we typically see from this group, but the silver lining is that some of the key results were not as bad as many feared – driving stocks to rally.3
Looking ahead, inflationary pressures and supply-chain challenges will continue to factor for companies, but we are also hearing a lot more about the negative impact of the strong US dollar (which I will write about next week) and signs of weakness among lower-income consumers. How these issues continue to impact shifting earnings estimates will be crucial for investors to track.
Bottom Line for Investors
It is important to remember that the stock market is a discounter of future economic conditions – not economic conditions today. That’s why the three economic fundamentals I think investors should keep an eye on in the second half of 2022 are all leading indicators, not lagging or coincident indicators. Looking ahead, I do not see severe warning signs appearing just yet, but the environment is becoming more challenging.
1 Fred Economic Data. July 29, 2022. https://fred.stlouisfed.org/series/T10Y3M#
2 Conference Board. July 21, 2022. https://www.conference-board.org/topics/us-leading-indicators
3 Zacks.com. July 28, 2022. https://www.zacks.com/commentary/1960253/taking-stock-of-the-earnings-picture
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