Without a doubt, investing in financial markets requires its fair share of decision making. Given the assumption that individuals are rational in their decisions, market knowledge and depth would want to be known a-priori for a better understanding of the state an economy is in. In assessing an economy, market indicators help investors form opinions on the direction of financial markets, and these come in the form of leading, coincident and lagging factors.
Leading indicators are, more often than not, usually determined through the markets. Equity prices and bond yields can help determine the direction investor sentiment is taking vis-a-vis specific asset classes. Let’s take bond yield as a typical example; falling government bond yields could indicate, amongst other things, pessimism by investors on the economic outlook, as government bonds (Investment grade) are usually the main safe haven assets investors turn to in times of uncertainty and volatility and is usually symptomatic of an increase in risk aversion. The opposite occurs when sentiment takes a turn in the opposite direction and risk-on mode kicks off.
As markets cannot be predicted with a great deal of certainty due to its dynamism, investor money flows are monitored closely to generate a broad globalised opinion on the path global investors believe an economy to be taking.
In hand with lagging indicators, efficiently reading and identifying leading indicators is crucial for investors and investment managers alike in order to beat (or at best mirror) market benchmarks in their asset allocation and decision making processes.
Market benchmarks often consist of a pool of securities belonging to a generic or concentrated sector of the economy. Commonly known benchmarks include the S&P 500 and FTSE 100 indices, which are equity indices in the US and UK respectively.
Fixed income benchmark indices also exist but are not as widely popular with retail investors as their equity counterparts as they rarely make the news (albeit form an integral part of a fixed income asset manager’s day to day performance analysis), whereby bonds with similar credit ratings and maturities are pooled together. The performance of fixed income benchmarks in fact help investment managers to gauge their performance versus comparable benchmarks, while over performance, better known as alpha within the investment jargon, would be brought about by the underweight/overweight position a Manager would have taken when compared to the benchmark.
Lagging indicators, meanwhile, are available through monthly economic data figures issued throughout respective economies. The main determinants of an economy’s wellbeing fall upon inflation data, the labour market coupled with unemployment rates and industrial production levels. Many more indicators exist but the aforementioned are some of the most crucial.
It is important to note however that a positive set of data results for a previous month’s data range does not necessarily justify the current economic situation, although there would be a high probability that positive momentum should continue, bar any significant headwinds and volatility.
In fact the current ongoing global volatility has proved difficult for investors to combine both lagging and leading indicators in generating long term strategy. Leading indicators are, more often than not, backward looking and do nothing to predict the future strength of the market, but are a key gauge for asset managers in assessing market trends. With no indications of global uncertainty fading anytime soon, lagging indicators and central bank decisions are unfortunately going to continue making up the biggest part of investment decisions, given the ambiguity of ever changing leading indicators.
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