The Paris-based Organisation for Economic Development and Co-operation (OECD) has published its composite leading indicator (CLI) for the month of February. For the first time in 17 months, the signal is now negative. The leading indicator fell by 0.07 percent, which moves the global economy from an expansion and into a slowdown, according to our business cycle model (see fact box and figure 1). The setback is modest, only visible on the second decimal, and may yet be revised in the next month. Nonetheless, the result is important in terms of how I approach the global business cycle.
Figure 1: OECD leading indicator
The slowdown in February is mainly driven by the US, thus repeating the signal from other early indicators. Extreme weather in North America may ultimately be the cause of this, but we still lack hard evidence that spring is bringing a return to higher growth rates. In contrast, the results from Europe are mostly positive, confirming a general trend towards higher growth there. Outside the OECD area, main emerging markets continue to signal a further slowdown ahead, and I continue to advise caution when investing in the region.
We expect growth to pick up in the second quarter in the US as well as in Europe, and hence we are looking for this to be a temporary setback. These growth pauses are often referred to as mid-cycle slowdowns, lasting a few months. Both 2006 and 2010 saw examples of such pauses.
The difference between expansion and slowdown
There is a clear difference between expected financial returns in the various parts of the economic cycle. We use these insights to guide our tactical asset allocation stance. Economic expansions, like the one we have seen since January 2013, are characterised by positive returns on equities and a clear outperformance of stocks vs. bonds. As we shift into a slowdown, the expected returns on stocks fall to the same level as for government bonds, and investors are thus not compensated for the higher risk on equities.
Quite often we do see a new record high in the equity markets early in a slowdown, followed by a more negative trend. Only in an economic downturn (recession) does the expected return on equities become negative. Much will depend, therefore, on whether we are facing a short setback or moving towards a recession later on this year. Normally, we look to reduce financial risk during the slowdown period.
Figure 2: MSCI World (total return)
