Economic Sentiment Indicator as an early sign of Recovery?

My single most favorit economic indicator is the monthly Economic Sentiment Indicator (ESI) of the European countries, provided by Eurostat.

Of course, this indicator has its flaws. It’s survey-based, first of all, which makes it vulnerable to ‘opinion’ and ‘trends’. Secondly, the one that I’m using most (from Eurostat) is being challenged by a multitude of other business and consumer confidence surveys, so why favor that one ?

Well, the major reason is that it’s telling quite an interesting story.

Let’s start with an example for Europe (EU 27):

(Source: Eurostat December ’08)

In those charts, I compare the monthly Economic Sentiment (at quarter end) with the Nominal GDP change for that quarter (q/q change).

Why take the Nominal GDP instead of Real GDP or GDP by Volume ?

I’ve built those charts using the 3 GDP figures, and the Nominal GDP is the only one where a clear correlation could be found. Thinking of it, this is logical. Nominal GDP doesn’t factor in the inflation, which would have a delayed and somewhat confused impact on the ‘real’ economy anyhow (consumer spending typically is slow to respond to high inflation).

Comparing the economic sentiment with nominal GDP tells the story of how people and companies feel their current wallet content will cope with how they perceive their near-term future. Probably some anticipation of future inflation is factored in -especially in disruptive times as we’re currently experiencing. But then, this is embedded in how people and companies perceive their future, which in turn is translated in the Economic Sentiment…

What can we learn from this chart ?

The most striking conclusion is that there seems to be a strong correlation between the Economic Sentiment and the Nominal GDP quarterly change: they seem to follow the same flow.

But which one leads to the other ?

Take a close look at the chart, the pattern that you’ll see emerge is that the feeling of the economic players (as expressed by the Economic Sentiment) is lagging just a little bit whenever the economy is declining, and leading just a tiny bit whenever economic tides are turning positive again.

This somehow makes sense if you take into account that the Economic Sentiment Indicator is a mixture of feedback from companies and consumers: companies will see their order books declining with some delay when times get rough, and consumers will be oblivious to economic downturns for a little while when those downturns occur.

On the other hand, after a rough ride, the economic sentiment is likely to turn positive at the first –even slightest- signs of recovery.

In short: economic players are slow in getting pessimistic, but are eagerly awaiting any sign of positiveness.

A closer look at the ESI of major Western European countries

(all figures are in Quarters except for last 2 data points which are in months)

(Source: Eurostat data December ’08)

For all those countries, we saw a sharp decline of Economic Sentiment starting just one year ago. At first sight, it looks like the economic actors surveyed were getting overly pessimistic in comparison to the Nominal GDP growth, but the declining ESI coincides strongly with the Inflation which was getting out of hand in the same period (and, hence, with the Real GDP slowdown).

Seen that way, whenever inflation is getting out of control, it has a clear negative impact on the overall economic sentiment. Of course, other factors didn’t help, like the financial crisis which was lingering but really broke through this year, or, in case of the UK, the housing crisis. Regardless of inflation or Nominal GDP, those type of evolutions are likely to impact the Economic Sentiment as well.

Long-term evolution of the Economic Sentiment

(Source: Eurostat data December ’08)

The current drop in Economic Sentiment is only comparable to the one from 1987-93, but back then the countries moved with different pace, while they are now declining in concert…

What can we take from all this ?

1. If the Economic Sentiment Indicator is indeed a leading Indicator for how the Nominal GDP moves, the worst is yet to come;
2. However, compared to historic movements, the economic actors surveyed for the ESI seem to be overly pessimistic;
3. The longest decline of the ESI in recent times lasted 5 quarters (1995-96 and 2000-02). We are currently in the middle of the 5th quarter of declining ESI;
4. From a longer perspective, the European countries are heading to a historic low;
5. An reverse of negative ESI trend is likely to prelude an upward trend in economic activity.

I know the world is much more complex than the picture that is being drawn here, but my major point was to highlight the relevancy of tracking the Economic Sentiment as provided by Eurostat.

Frederic