Each month the OECD produces an interesting set of composite leading indicators (“CLI”) showing cyclical fluctuations around a long term average over time for the major global economies. The set is quite smooth with distinct turning points, which is somewhat unusual given all the noise associated with economic data. However, this comes at the expense of timeliness, with the most recent data going back to last August.

But there is another way of looking at the data that can provide early confirmation (if not indication) of cyclical changes in the global economy. And that’s when China is used as a leading indicator.

In the graph above China’s CLI is shown in red and the OECD (developed) countries’ in blue. Notice how since the mid-1990s, when China embarked on its quick march towards industrialization, most of its business cycle turns have preceded those of its developed counterparts, sometimes by several months.

During the 2008 financial crisis both CLIs become much more synchronized given the contagion that quickly spread around the world, but China was the first to bottom yet again, even if only by a month or so.

We find a similar pattern when comparing the indicator with a vital economic commodity like crude oil on a monthly basis (log scale), as shown in the graph above. Changes in China’s CLI tend to precede major turning points in the price of crude oil (which of course is much noisier), with some exceptions. We can also compare it to the US’ CLI. A rally in crude oil prices appears more sustainable when China’s CLI is above the US’; weakness is expected when the opposite applies, with the notable exception of the late 1990s blow-off in crude oil prices.

Since the China series only started in the early 1990s there aren’t that many observations, covering only a couple of recessions and financial crises. As such these findings lack statistical robustness but they do bring up an interesting question: why would China almost always lead the developed world’s business cycle, and not the other way around?

We postulate that this is due to the relative composition of China’s economy. The greater proportion of manufacturing in relation to the developed world means that things now tend to happen there first: the buildup of order books, the ramp up of steel production, the purchase of raw materials to restock inventories, the increased energy consumption and so forth. All this creates momentum across the global supply chain, eventually reaching the service sectors which are dominant in most OECD countries.

So it’s more like manufacturing being the leading economic indicator rather than China per se. But the signals are quite insightful. Going back to the graph we note the following:

  • Unlike its OECD counterparts, recent readings of China’s CLI have been at depressed levels – only seen during recent financial crises and recessions. This is somewhat at odds with official GDP growth statistics, but not with the correction we have seen in commodity prices;
  • China appears to have turned a corner and its economy is gaining upside momentum, unlike the US and other OECD. If sustained this should be good news for a weakening global economy, even if it can take a few months for the ripple effect to go through (barring any major crises, which tend to synchronize everybody to the downside). We are close to reaching that crossover with US’ CLI that historically has provided a bullish context for higher oil prices;
  • While turning points do seem to go in the new direction for some months, there is nothing preventing a reversal from suddenly emerging. And indeed we have seen this a few times already since 2010, with China’s CLI becoming more “wavy” despite all the smoothing that goes into the indicator. In other words, the economic environment is riskier now.

Evidently it is difficult to construct a market timing model for commodities or stocks given the time lag of the series but it can still provide a useful confirmation (adjusted for probabilities, which clearly are not 100% within the fairly limited number of available observations) of where the economy should be heading.

It thus appears that it is not only when the US sneezes that the rest of the world catches a cold; China may already be in bed by then. It’s worthwhile keeping a close eye on its economy.