On LEI: Is a Popular Recession Indicator Broken?

How is the US economy faring? Not too bad, according to most widely watched data. But one typically reliable forward-looking indicator—the Conference Board’s Leading Economic Index (LEI)—flashed red again in September’s report, extending a yearslong trend. Normally, such a trend would precede recession. Yet this time, it hasn’t. LEI’s struggles provide a timely reminder to dig into dashboard indicators to assess the underlying reality before presuming they are assuredly right.

US LEI fell -0.5% m/m in September, and of the gauge’s 10 components, only one contributed positively: stock prices (as measured by the S&P 500), which added 0.11 percentage point (ppt).^[i] Five were flattish while four detracted—with manufacturing new orders (-0.20 ppt) and the interest rate spread (-0.18 ppt) subtracting the most.

Last month’s weakness isn’t new. September’s four detractors have sagged the past six months, led by the Institute for Supply Management’s (ISM’s) New Orders Index’s -1.09 ppts subtraction amid the global manufacturing slump.^[ii] Overall, LEI has been falling since December 2021. (Exhibit 1)

Exhibit 1: US LEI Over the Past Decade

Source: FactSet, as of 10/28/2024. US LEI, October 2014 – September 2024.

Generally speaking, LEI does a fine job capturing how the broad economic backdrop is shaping up since it relies on mostly forward-looking data. For example, new orders reflect future production while the yield curve spread represents banks’ future profit margins. The latter influences banks’ willingness to lend capital that households and businesses can spend and invest—fueling growth. That is why an extended, deep LEI decline historically indicates a recession is either imminent or underway.

But pandemic-related developments have made LEI less telling right now, in our view. Take September’s two largest detractors: new orders and the interest rate spread. The former reflects manufactured goods demand—which has been weak for a while. As we have written, pandemic-driven lockdowns pulled forward demand for physical goods, leaving a pothole in their wake. This flipped when businesses reopened and consumers went back to spending on services—knocking manufacturing production.

As for the interest rate spread, the yield curve has been inverted for most of the past two years, but it didn’t lead to a deep credit contraction. Since the lockdown-era savings surge contributed to a deposit glut, banks didn’t need to borrow at rates near the fed-funds rate. Lending slowed, but it didn’t contract.

Beyond the return to a post-COVID normal, LEI also skews toward manufacturing and goods-producing industries—which make up less than 20% of US GDP.^[iii] Whether manufacturing is in a soft patch or strong upturn, its prospects don’t automatically reflect America’s services-dominant economy.

Moreover, LEI doesn’t have a perfect record. It was flat heading into the 2008 – 2009 recession, prompting the Conference Board to review its composition. That led to a restructuring and replacement of several components in 2012.^[iv] Out went real money supply (M2), the ISM’s Supplier Delivery Index, the Reuters/University of Michigan Consumer Expectations Index and the broader new orders for nondefense capital goods. Swapped in their place: the “Leading Credit Index,” ISM’s New Orders Index, an averaged aggregate of consumer expectations and the narrower new orders for nondefense capital goods (excluding aircraft).^[v]

Note, too, this wasn’t LEI’s only restructuring. Back in 1996, the Conference Board removed materials prices and manufacturers’ unfilled durable goods orders from its LEI composite index while adding the yield spread—arguing the latter “clearly ranks above average as a leading indicator because it consistently turns in advance of the business cycle.”^[vi] As the economy has evolved over time, LEI has evolved to stay relevant—true of many economic indicators, including GDP.

Perhaps the Conference Board will update a future version of LEI with some services-oriented measures to better reflect the modern economy. But for now, we think LEI’s current false signal is a reminder to not take the headline reading at face value. It remains critical to look under the hood and understand why components are flashing red (or not). Doing so can help investors determine what the crowds may or may not be missing.