It’s never easy to predict where the economy will go next, especially these days. With so much riding on data and the Fed’s interpretation, it has been easy for investors to position themselves where the puck is headed, and most have been playing catch-up all year.
But Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America, wrote in a recent note to clients that she and her colleagues have compiled a range of economic information into a comprehensive indicator that could point the way. .
“Admittedly, the past few years have not been well-defined from a ‘cycle’ perspective, including asynchronous fluctuations during and after COVID-19,” Subramanian wrote. “But our US governance indicators remain relevant in capturing factor trends – for example, the January to June recession saw mega-caps, growth and quality outperform, which is true.”
Now, that indicator has changed. Rather than pointing to a recession, the data indicate that the US economy has shifted into a new phase of the economic cycle.
What will happen to the US economy next?
Bank of America’s economic indicators have made a sudden upward move from the low of the “recession” phase to the gradual strengthening of the “recovery” phase.
Bank of America
This indicator consists of eight key pieces of macroeconomic data, listed verbatim below:
- earnings revision ratio: The number of S&P 500 companies that have higher Thomson Financial consensus earnings estimates, versus lower estimates. Increasing ratio = improving cycle.
- ism pmi: ISM PMI Institute for Supply Management Manufacturing Purchasing Managers’ Index, Z-Score. The ISM PMI 300 tracks activity reported by supply management professionals. A reading above 50 indicates expansion.
- inflation: 12-Month Change in the BofA Inflation Composite…as a Z-Score. Rising inflation indicates improvement in the economic situation.
- GDP forecast: Forecast of US GDP growth over the next 12 months from a Federal Reserve Bank of Philadelphia survey, expressed as a Z-score.
- Leading Economic Indicators Index: The 12-month change in the Conference Board US’s leading index of ten economic indicators, expressed as a Z-score. An increasing Z-score indicates improving economic conditions.
- US capacity utilization: 12-month change in US capacity utilization, as a Z-score. Capacity utilization rate shows the percentage of total economic capacity that is utilized. Increasing capacity utilization means improving conditions, increasing demand.
- 10-year US Treasury bond yield: The 12-month change in bond yields expressed as a Z-score. Increasing yields indicate improvement in economic conditions.
- High Yield Corporate Bond Credit Spread: 12-month change in US high yield credit spreads for the ICE BofA US High Yield Index, expressed as a Z-score. Falling spreads indicate improvement in economic conditions.
According to Subramaniam, three of those data points declined month-on-month: EPS revision ratios, key economic indicators, and high-yield corporate bond credit spreads.
But five of the eight indicators improved – and what’s more, they improved for the second month in a row. This tells Subramaniam and his colleagues that the economy is changing, and smart investors need to move beyond looking at the past.
How to invest when the economy recovers?
Subramanian said that, in previous instances when the economy has entered a recovery phase, many stock-market sectors have outperformed.
“The sector’s performance in previous recoveries was clearly cyclical: financial situation, industrial- And Material “Performed well, while utilities, health care and staples performed poorly,” Subramaniam wrote.
In fact, in the last 100% recoveries the financial sector has outperformed – and in the last 100% recoveries, the utility sector has underperformed.
Bank of America
Subramaniam actually went a step further, extending his economic governance indicators beyond 20 years of data, going back to the 1970s, when the US was experiencing a different inflationary crisis.
Subramaniam wrote, “When the Fed fought inflation in the 70s, it followed several hike cycles to control inflation. Even after the Fed ended, value continued to lead growth for the next 12 months.” “Small caps mostly led large caps before the last hike (except last month), faltered in the 3 months after the last hike, but led large caps in the subsequent six-month and 12-month periods,” Bond said. “Equities generally led before the last rise, and have led consistently thereafter (supporting our overweighting of bonds-like the utilities sector).”
Of course, a lot has changed since then and in just the 20 years since Bank of America takes its data for economic governance indicators. Subramaniam said the indicator does not consider things like the high beta of the technology sector in the 1990s, or the slow volatility of the energy sector’s earnings.
However, the indicator has a strong history of telling the right investing style. Subramanian said the indicator shows deep value stocksas well as high risk stocksThey are positioned to benefit from the economic recovery, even though they lagged the market in August.
He also pointed out High-Dividend Stocks It has lagged the market recently, but historically speaking, the group has performed strongly due to the recovery phase of the economy.
“The highest dividend-paying stocks have been neglected (51% underweighted by long-term funds) and valuations are two cents below average, favoring outperformance in the coming months,” he wrote.