• Disappointment. The unexpected setback in the purchasing managers indices has dampened hopes of a rapid trend reversal for the euro-zone economy. The miserable state of the economy at the end of the year will continue in the first quarter. GDP will contract strongly again at the beginning of the year (page 17).

  • Hope. In contrast, the second consecutive strong gain in the Ifo expectations component this week has underpinned hopes of an improvement after mid-year. Ifo expectations are the most reliable leading indicator for German industrial production. We see the trend reversal here in spring (pages 2-4).

  • Uncertainty. It is, however, still highly uncertain whether this will ultimately result in the German and European economy stabilizing in the second half of the year. For this to happen, the leading indicators will have to rise rapidly in the coming months from their still strongly recessionary levels (cf. chart).

  • Strains. The end of the recession after mid-year is quite possible, but very ambitious at the same time. Despite the already unprecedented meltdown and the fiscal stimulus measures, the downside risks remain high. The housing bubble is still deflating and - following in the footsteps of the US - the labor market outlook has also deteriorated rapidly in Europe. On top of that, the cold winter is eroding the boost to purchasing power from strong disinflation via higher heating expenditures (p. 5-7).

  • Further topics:

    – Spain: No easy way out (page 8).

    – Data outlook: ECB and BoE to cut rates; US: Ugly employment report (page 11).

    – Market outlook: Periphery becomes more attractive; USD remains firm (page 19).


German leading indicators' ambitious message

  • After this week's second consecutive increase in the Ifo expectations component, one endangered species has managed a comeback: hope.

  • Optimists point out that the improvement in forwardlooking sentiment indicates a stabilization of the German economy in the second half of this year. In contrast, pessimists argue that it is too early to give the all-clear.

  • We tested a raft of leading indicators and their corresponding message for the German economy. The Ifo expectations index is clearly top-ranked in terms of statistical significance. However, there are other indicators worth watching, like EMU M1 growth and the Baltic Dry Index.

  • The majority of leading indicators signals that the trough in industrial production should occur in spring 2009. However, managing a turnaround does not automatically equal an end to the recession. Although leading indicators improved recently, they are still at historically low levels.

  • The Ifo expectations component, for example, has to increase strongly from currently 80.9 to more than 93(!) in the months ahead to signal zero "growth" in industrial activity.


Glimmers of hope

After the recent increase in the Ifo expectations component and the renewed rise in the ZEW, one endangered species has managed a comeback: hope. Although hard data, like new orders and industrial production, continued to be lousy, the forward-looking Ifo expectations reading edged up for the second consecutive time.

Since then, glimmers of hope have been seen. Optimists point out that the improvement in sentiment indicates a stabilization of the German economy in the second half of this year. In contrast, pessimists argue that it is too early to give the all-clear. In the following, we tested a raft of leading indicators and their corresponding message for the German economy – the well-known usual suspects, like the Ifo business expectations figure or the ZEW, but also some rather unknown quantities, such as the Baltic Dry Index.


Separating the wheat from the chaff

In the first step, we tested whether the indicators do have any significant explanatory power in forecasting turnarounds in the German economy. As an econometric yardstick, we used so-called Granger causality tests proposed by Nobel Prize winner Clive Granger. The basic idea of this approach is pretty simple. A leading indicator X, like the Ifo expectations index, is said to "Granger-cause" Y (German industrial production), if X helps improve the forecasts of Y.

Before plunging into the results, we first give a short overview of which leading indicators have been taken into account:

– The Ifo business expectations component reflects German companies' outlook for the coming six months.

– The ZEW growth expectations contain the outlook of economists and asset managers for the German economy in six months' time.

– The OECD Leading Indicators for Germany is a composite of several business cycle gauges, like order books, the level of inventories, etc.

– The German Purchasing Managers' Index reflects the opinion of business managers. It is probably best compared to the overall Ifo index which contains expectations and assessments of the current situation.

– The DAX as the most important German share price index contains expectations of the future profit of companies. Hence, share prices might be a good gauge for the overall business cycle outlook.

– The S&P500 as a prominent share price index should reflect future profits of US companies. Given the importance of the US economy, the S&P500 could be a global leading indicator.

– According to the monetary business cycle theory, monetary aggregates, like EMU M1, might reflect information about spending decisions of companies and consumers. An acceleration in money growth therefore equals increasing economic momentum1.

– The yield spread between 10Y Bunds and the 3M rate is also regarded as a leading indicator. A widening spread might reflect interest rate cuts by the ECB and/or rising 10Y real yields. These factors could signal a turnaround in the business cycle. For example, an increasing real interest rate equals higher GDP growth.

– The Baltic Dry Index reflects freight costs around the world, i.e. rising freight costs might signal a recovery in global trade. The shipping industry is especially appealing, as about 97% of all goods and commodities between continents are transported by sea.

We ran Granger causality tests between these nine indicators and German industrial production (in % y-o-y; cf. first chart on previous page). The reason for choosing the latter yardstick is straightforward, since: a) manufacturing companies are very sensitive to the (global) business cycle and b) the industrial sector was a powerhouse of German growth until last year. Hence, if the overall economy will really manage a turnaround in the second half of 2009, it should be felt early among manufacturing companies.

Our results convey two important messages. First, as can be seen in the table on the next page, the Ifo expectations index is clearly top-ranked in terms of statistical significance. The higher the F-statistic, the less is the likelihood that the indicator is giving the wrong signal. Hence, investors and economists alike should take business expectations at face value. Second, there are other indicators worth watching. Apart from the OECD Leading Indicators and the PMI, additional gauges also have predictive power in forecasting German industrial production. For example, the DAX, EMU M1 money growth and the Baltic Dry Index – to name a few – usually send reliable signals. In contrast, the German yield spread (10Y-3M) and the S&P500 do not convey any significant message.


Ambitious but not impossible

Statistical significance is one important puzzle piece in the quest for crosschecking the Ifo's and the ZEW's latest message. Another major feature is leading indicators' ability to look as far as possible into the future. The longer the time span between the respective indicator and industrial production, the more useful is the business cycle gauge. We calculated the average time horizon between turnarounds in leading indicators and industrial production. For example, changes in the Ifo expectations component precede variations in industrial production by four months on average (cf. table on next page). In assuming that companies' business expectations really turned the corner in January, the turnaround in industrial activity should be seen in May 2009. Hence, the brutal recession will continue for the time being. Other leading indicators, like EMU M1 growth, the ZEW and the Baltic Dry Index, confirm this sobering picture. The DAX and the ISM even signal that a trough in industrial production will only be reached after the summer break.

Getting the timing of the trough right – and hence the absolute low point of economic activity – is one crucial thing for leading indicators. But how long will it take until the current recession is really over and we see at least zero "growth"? Please keep in mind that a turnaround in leading indicators does not automatically equal an end to the recession. Some business cycle gauges improved recently, but they are still at extremely low levels. In other words, the economy will still be shrinking then, albeit at a slower pace. We therefore calculated two further statistics: first, leading indicator levels which are in line with zero "growth" in industrial production; second, the average change of leading indicators after managing turnarounds, i.e. how quickly levels which are consistent with stabilization can be reached.

According to our estimates, we are still far from levels which signal an end to the recession. The Ifo expectations component, for example, has to increase strongly from currently 80.9 to more than 93 (cf. table). Only then – repeat: only then – will industrial activity (on a y-o-y basis) shrink no further. Unfortunately, the monthly change of business expectations after hitting their trough was a mere one point on average in the past. In other words, given the historical experience after German reunification, it is ambitious to believe in an end of the recession immediately after the summer break. This not very encouraging message can also be derived from other leading indicators. The Manufacturing PMI has to increase to about 48 in order to signal stabilization2. Again, this is not easy to reach, as the current level is 32.2 and the average monthly change is only 1.2 points. The same logic applies to the OECD Leading Indicators, the DAX, the ISM and the Baltic Dry Index. Currently, there are only two indicators which are sending a more optimistic signal: the ZEW and EMU M1 money growth. According to the recent ZEW figure of -5.8, the critical threshold of -14.9 has even already been passed. Consumer-price adjusted money supply growth currently equals +4.1% with a "neutral" level of only +2.0%.

Our bottom line: The good news is that the signs of an impending turnaround in hard economic data have been mounting over the last few weeks. Hence, a doomsday scenario à la Great Depression has become more and more unlikely. Instead, the majority of leading indicators signal that the trough in economic momentum will be reached in spring 2009. Afterwards, things will improve, i.e. the pace of shrinking activity will ease. Let's be grateful for that! However, there is also bad news. Our calculations showed that a scenario with zero "growth" already in Q3 2009 is ambitious. We think it is not a mission impossible, as history might not repeat itself. Many leading indicators fell to unprecedented low levels – they might bounce back again more rapidly than in previous cycles. However, we would like to stress this point again: Our scenario of economic stabilization is ambitious and not a done deal. There are risks that zero "growth" will only materialize later this year.