Index of Leading Economic Indicators (LEI) (Predicts direction of the economy 6-9 months down the road) Web address: Monthly revisions Published monthly by the Conference Board, a private business research group in New York City. The Commerce Department originally published the index in 1959, but sold the data series to the Conference Board in The index is a composite of a select group of 10 economic statistics (3 financial and 7 nonfinancial components) that are known to lead the rest of the economy. Because each business cycles is different from the last, it is difficult for firms to predict corporate sales, profits and employment. The LEI has done a fairly respectable job of signaling peaks and troughs of an economy some 3-9 months down the road. While the LEI has successfully predicted recessions in the past, the LEI has also declined without a recession taking place (false signal). Humorists have noted the LEI has predicted 9 of the last 6 recessions. The LEI is better at predicting a bottoming of the economy and an economic recovery. The Conference Board periodically refines the index to improve its predictive performance. Watch the LEI 6-month percentage change for economic turning points. Also watch to see how many of the components are moving in the same direction (the breadth or diffusion of any index move). The conference Board also publishes the Coincident Indicators Index (moves in tandem with the economy and captures its peaks and troughs) and the Lagging Indicators Index (confirms that a certain part of the business cycle has passed). The 12-month percentage change in the Coincident Indicator is a good proxy for GDP growth. LEI Components Interest rate spread between the 10-year Treasury bond and the federal funds rate Leading Credit Index Stock prices based on the S&P 500 stock index Average hourly workweek in manufacturing Manufacturers’ new orders for consumer goods and materials ISM Index of new orders Average weekly initial claims for unemployment insurance Building permits for new private homes Index of consumer expectations by the University of Michigan Manufacturers’ new orders for nondefense capital goods Various LEI Rules of Thumb to Predict Economic Turning Points: A downward move in the LEI index of more than 2% over six months coupled with declines in a majority of the 10 components portends a recession. If the LEI falls for 4 out of 7 months and the Coincident Indicator drops 3 consecutive months, then expect a recession in 3-6 months. 3 consecutive declines in the LEI warns of an economic decline in 3-9 months. 3 consecutive increases in the LEI portends the end of a recession in 3-9 months (The above 4 different rules of thumb highlight how subjective the science of economic forecasting can be) Market Analysis: Bonds: 3 month LEI  => recession =>  (  P/P) E t+1 =>  D Bonds =>  i Bonds Stocks: 3 month LEI  => economic recovery =>  sales =>  profits =>  equity holdings =>  P Stocks Dollar: 3 month LEI  => economic recovery and higher interest rates =>  sales =>  profits =>  equity and bond holdings by foreigners =>  capital inflows => appreciation of dollar

Purchasing Power Parity In the long = P.L. Canada $ P.L. U.S. E will adjust so that it is possible to buy the same market basket of G/S with the equivalent amount of any country’s currency. Purchasing power of each country’s currency is the same If PPP holds, then no arbitrage profit opportunities. If not PPP, then arbitrage profit opportunities exist.

Dollars and gold are currency substitutes. Both serve as a store of value. A fall or expected fall in the value of the dollar create incentives to shift towards gold.

THE GREAT DEBATE: Stimulus Vs Austerity J.M. Keynes Father of Modern Macroeconomics “The General Theory of Employment, Interest and Money” Advocated the use of fiscal and monetary measures to offset recessions. AD determines the overall level of economic activity. The modern capitalist economy does not automatically work at top efficiency, but can be raised to that level by government intervention. F.A. Hayek Nobel Prize “The Road to Serfdom” Changing prices communicate signals to enable individuals to coordinate their plans. This leads to an efficient exchange and use of resources. Leading critic of collectivism/socialism because it required a central planner that would eventually become totalitarianism. The free price system is a spontaneous order – the result of human action, but not of human design. Central banks do not possess the relevant info to govern the money supply, nor the ability to use it correctly.

$/Yuan Yuan/$ Yuan 6.35 / $1 $0.157 / Yuan

Imports and Exports Price Indexes (Measures Goods/Services Prices Changes of Exports/Imports) Web address: Monthly revisions going back 3 months. Every January, the weights of products in the basket are changed, and reflect shifts in trade patterns 2 years earlier. The price indexes convert the monthly U.S. trade figures from current dollars (P t Y t ) to real dollars (trade flows in real terms). Allows an analysis on why trade flows changed; a change in prices or a change in quantity (price or volume effect). Monthly data on the transaction prices of trades on 20,000 products from 600 companies is collected. Import prices are “free on board” (FOB) which does not include the cost of insurance and duty taxes. This reflects the value of product at the foreign port of exportation. Seller is responsible for placing the goods on a boat or plane. Export prices are “free along ship” (FAS) which represents value before loading. The behavior of export and import prices affect the costs of trade. A rise in the price of imports can have a palpable impact on inflation in the U.S. and is considered a forward looking sign of inflation pressure. (examples: increase in the price of Columbian coffee or Saudi oil). The dominant factor behind changes in import and export prices is the rise and fall of the U.S. dollars value in the currency market. A decrease in the U.S. dollar exchange rate will increase the price of imports. e P EU x ($/e) = $ P M US Import and export prices have a direct impact on the competitive position of U.S. in foreign markets. Rising export prices => falling quantity demand of U.S. exports => rising unemployment rate => falling GDP. U.S. importers prefer to deal with nations whose currencies are weak because they can purchase goods more cheaply from them, than from stronger currency nations. But U.S. exporters face serious headwinds selling into a market whose local currency is falling If U.S. inflation increases or the U.S. dollar appreciates, then the quantity demand for U.S. exports by foreigners will fall as they switch their purchases to other countries. This will reduce U.S economic growth. Recall Purchasing Power Parity (PPP); $/e = P.L. U.S. / P.L. EU Recall Real Exchange Rate; r = e/$ x (P.L. U.S. / P.L. EU ) Wine example: Assume the price of wine in Europe = 25 euros and the exchange rate E = $/e = $1/e1. So the price of imported wine in the U.S. is $25. If the Euro appreciates 25%, then the cost of imported wine in the U.S. rises to $31.25, a 25% increase. This will contribute to rising inflation in the U.S and an increase in U.S. producers’ wine prices. The dollar depreciates to e0.8/$1 (a 20% decline) so the price of U.S. exported wine to Europe falls 20%. This leads to rising quantity demand for U.S. exports and rising sales and profits Market Analysis: Bonds:  P M =>  (  P/P) E t+1 =>  D Bonds =>  i Bonds Stocks:  P M =>  production costs =>  profits =>  P Stocks  P M =>  domestic producers sales =>  profits =>  P Stocks  P X =>  foreign sales =>  profits =>  P Stocks (firms have different exposure to the global market place, some import commodities and inputs and others compete with final goods) Dollar:  P M =>  (  P/P) E t+1 => possible policymaker intervention into the FX market

e P EU x ($/e) = $ P M US