Numbers

While economic numbers like GDP or the monthly non-farm payroll report typically garner the headlines, the most useful statistic in my opinion–  the Chicago Fed National Activity Index (CFNAI) – often goes ignored by investors and the press.

That may be a mistake. Markets have run up sharply in recent months partly on the assumption that US economic growth is going to accelerate later this year and translate into faster earnings. But if recent CFNAI readings are any indication, investors may want to alter their growth assumptions for the third and fourth quarters.

Unlike backward-looking statistics like GDP, the CFNAI is a forward looking metric that gives some indication of how the economy is likely to look in the coming months.

And of all the indicators I’ve tested, the CFNAI has the best track record of forecasting future GDP. Since 1980 the CFNAI has explained roughly 40% of the variation in the following quarter’s GDP, an extremely high proportion for a single indicator.

So what has the CFNAI shown lately? The indicator has been negative for the past few months. And last week, it plunged to -0.52 for April, as the chart below shows.

While the CFNAI’s current level is still consistent with economic growth, it does suggest that growth will sharply decelerate in the second and third quarters of this year, falling to about 1.8%.

To be sure, as the chart above shows, the 3-month moving average indicator has remained around 0 for most of the past three years. In other words, the CFNAI isn’t predicting a recession, but it is forecasting a continuation of the same slow-growth environment we’ve been in since mid-2009.

Unless the indicator significantly picks up in coming months, I expect the US economy to remain stuck in a slow growth mode for at least the next quarter or two. For investors, there are two implications:

1.)    Beware of paying a lot for cyclical earnings growth that may not materialize. Among cyclical sectors, I’d be particularly wary about consumer discretionary companies, which have some of the most aggressive earnings growth assumptions.

2.)    Expect more market volatility. All being equal, slower growth is normally associated with higher volatility. We’ve recently seen a modest pickup in volatility, albeit from a very low base. The CFNAI is suggesting that there may be more bumps to come.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.