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Lagging vs. leading indicators – what’s the difference and what investors need to know

We look at the difference between lagging and leading indicators, what they tell us, and what investors need to know.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Analysts and economists alike rely on a wide range of indicators to try to assess what direction markets and the economy could be heading. But not all indicators are made equal. There are some fundamental concepts that are important to understand before you try and make an assessment based on indicators.

One of the most important things to understand is the difference between a lagging and leading indicator. Both have their merits, and when used together can form a better picture than either can when used alone.

We delve into what these indicators are and look at a few examples that we follow on a regular basis.

This article isn’t personal advice. If you’re not sure if an investment’s right for you, seek advice. Past performance isn’t a guide to the future. Investments will rise and fall in value, so investors could get back less than they invest.

What are lagging indicators?

Lagging indicators are arguably the most common. Most metrics you’ll come across, whether looking at a company’s performance or keeping up to date with wider economic affairs, will be lagging. These provide a snapshot of what’s already happened after an event has taken place. They could be called hindsight indicators.

It’s hard to imagine that looking at things in hindsight has any value. But, historical trends can offer invaluable insight when analysing the performance of a company, market, or economy.

Consumer price index (CPI) is one of the most common lagging indicators and is typically used as the headline figure for inflation. It’s calculated by taking the average weighted cost of a basket of goods and services, comparing the cost to previous months and years. There are several variations that change what’s in the basket, most notably CPIH which includes the costs associated with maintaining your home, but the premise remains the same.

The Office for National Statistics releases UK CPI data toward the end of each month, reflecting the change in prices from the previous month. On that basis, it’s always a lagging indicator. Nonetheless, it’s an extremely important measure of economic activity and influences both central bank and government policy.

Here’s how the index has shaped up over the last ten years.

UK Consumer price inflation (%)

Source: Office for National Statistics – consumer price inflation 29/06/22.

As an investor, knowing how inflation faired a month ago doesn’t necessarily tell you much. But looking at the overall trend can offer a sign as to how consumers’ spending power is shaping up.

We’re in a period right now where inflation has been trending high for several months. So it could, for example, be a good time to think about diversifying into investments that could perform well in that environment if you haven’t already. These changes shouldn’t be big shifts, but rather small tweaks.

Sectors like energy, real estate, and consumer staples have tended to hold up well in the past when inflation hits. Remember, there’s no guarantee that trend will continue.

2 share ideas to survive stagflation

In a similar fashion, the consumer confidence index is another widely used indicator. The index is based on a survey that asks people how they feel about their personal finances and wider economic conditions. Typically, we think about our finances after something has happened, which is why it tends to be seen as a lagging indicator.

If we look at how the UK fairs right now, there’s been a sharp drop this year. The index now sits below the lowest point during the pandemic.

UK consumer confidence

Source: Refinitiv Datastream, 30/06/22.

When we look at it with inflation, it’s clear UK consumers have been in a tight spot so far this year. Analysts and economists will be keeping a keen eye on how both trends continue.

Investors looking at individual companies will be well versed at using lagging indicators. You only need to look so far as a company report – revenue, profit and debt figures all tell a story of what’s already happened.

One of the most useful ways to interpret lagging data from a company’s annual report is using trend analysis.

The simplest method is to take a metric, let’s say operating margin, and compare it over several previous periods. Looking at how the trend’s evolved gives an indication of how well the company’s been performing. If, using this example, the trend shows operating margin decreasing, then it’s a quick way to flag a potential issue.

Investing in individual companies also isn’t right for everyone. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

When it comes to crunching the numbers of the companies you’re interested in, we can do a lot of the heavy lifting for you. Sign up now to get the latest research and updates on more than 100 of the most popular stocks with our clients.

What are leading indicators?

Leading indicators are used by analysts and economists to try and predict which direction the economy is headed. It’s important to remember these aren’t crystal balls, but when used alongside a range of lagging and other leading indicators, they can help paint a picture of what might come.

Arguably the most important leading economic indicator is the yield curve. It shows the interest rates available on government debt of varying timeframes. Under normal conditions, you’d expect the yield on a short-term bond to be lower than that of an equivalent bond with a longer maturity.

All being equal, an investor would require a better return if they’re parting with cash for a longer period. The steeper the curve, the more investors think conditions favour riskier assets, which would typically be a signal that economic growth is expected to be strong.

However, that’s not always the case and that’s when investors should pay attention.

UK GILT yield curve

Source: Bloomberg, 30/06/22.

The flatter yield curve we’re currently seeing in UK GILTs has historically been a signal that a period of slower economic growth might be around the corner. The next stage, which could point to more risk of a recession is if the curve inverts. That’s where longer-dated bonds offer a lower yield than their shorter dated counterparts.

Why all shareholders should pay attention to the bond market

Another popular leading indicator relates to the jobs market, specifically the number of people employed in manufacturing roles.

In a strong and budding economy, factories are working flat out to manufacture the goods needed to service a host of industries from retailers to transportation. That’s usually a good indicator that the businesses at the consumer end are heading for good times.

When manufacturers stop hiring, it’s a signal that demand for goods is falling and can be a leading indicator that a recession’s round the corner.

UK manufacturing jobs growth (seasonaly adjusted)

Source: Office for National Statistics, 30/06/22.

If we look at how that’s played out in the UK, when the pandemic hit there was a big decline in the number of manufacturing jobs. There’s been a strong bounce back since then, as the UK economy recovered. Some signs of weakness have crept back this year, which aligns with the general view that a recession could be on the cards.

What does this mean for investors?

The first step is to keep up to date with the range of measures listed here, although there are plenty more as well. The more information investors have at their disposal, the better chance of making better decisions.

The next thing to remember is that a diversified portfolio should include elements that can perform well in a range of environments. Current indicators suggest a recession could be coming soon, with cash strapped consumers and inflation continuing to climb. But if we zoom out far enough, this will hopefully be no more than a blip on the radar for quality companies that can survive, and even thrive, in hard times.

3 shares that could thrive in a recession

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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