Zacks Investment Management

The Leading Economic Index (LEI) Keeps Flashing Warning Signals

In June, The Conference Board’s Leading Economic Index (LEI) fell -0.3% month-over-month, marking the sharpest drop since February and adding to over two years of successive declines. Readers can see in the chart below that LEI has been in a near-freefall since early 2022.¹

Historically speaking, these consecutive LEI declines would be a troubling sign for the U.S. economy. The index is designed to be a predictive tool, built on 10 components ranging from unemployment claims to building permits to stock prices. As seen above, the past three recessions have all been preceded by a LEI that tops out and rolls over.

Yet here we are, two years removed from LEI’s peak and subsequent declines, with no recession on the books or in sight.

Does this mean LEI is no longer a reliable indicator for the U.S. economy, meaning we should ignore it altogether when making macroeconomic forecasts? Not necessarily, in my view. There’s some context that matters here.

The first big piece is taking into account pandemic distortions. As readers may recall, lockdowns and massive fiscal stimulus (in the form of direct transfers) pulled forward demand for physical goods, which created an unnatural spike in the manufacturing sector. Among the components of the LEI are average weekly hours in manufacturing, new orders, and building permits, which are all geared toward manufacturing and goods-producing sectors.

The issue here is that the manufacturing hangover (post-pandemic) has been a major drag on LEI, even though the sector accounts for less than 20% of U.S. GDP. The U.S. is a services-based economy, and there is not much services-based economic data that goes into the LEI calculation.

The skew here matters. In recent readings, much of the weakness in the LEI comes from falling new orders in manufacturing, declining average work hours, and a slight uptick in jobless claims. Meanwhile, the U.S. services economy, including consumer spending, healthcare, technology, and financial services, continues to hold up solidly. This helps explain why LEI has been in decline since mid-2022, even as U.S. GDP has continued to grow.

Another factor is the yield curve. LEI includes the interest rate spread between 10-year and fed funds rates, which has been inverted for much of the last two years (see chart below). Historically, an inverted yield curve has been a reliable recession signal, as relatively high borrowing rates can give way to a credit crunch. But banks today are still sitting on excess deposits from the pandemic era, muting the need to borrow at high short-term rates. Lending has slowed, but we’re not seeing a collapse.

I still think the LEI is a useful indicator for investors to track, even though its ability to predict recession has not panned out in this cycle. It’s an index that’s constantly evolving; the Conference Board revamped it in 2012 and removed outdated inputs like the M2 money supply and the University of Michigan sentiment index. Even earlier, in 1996, materials prices and manufacturers’ unfilled orders were replaced with the yield curve, reflecting changes in how we’ve come to understand economic inflection points.

Bottom Line for Investors

The trend in the LEI is worth watching going forward, but I don’t think we’re in a place where ‘it’s just a matter of time’ before the recession arrives. Much of the LEI’s current weakness reflects narrow slices of the economy that are not effectively capturing the full picture. Services remain strong, consumers are still spending, and corporate profits are holding up. These drivers represent the lion’s share of output. The key for market watchers is to treat LEI like one data point of many that you use to make forecasts and ‘check the pulse’ of the U.S. economy. No one indicator is sacrosanct or all-predicting.

Disclosure