The global economy is at something of a crossroads at the start of 2019.

China continues to slow, while in Europe, Italy has entered a recession, and the continent's economic powerhouse, Germany, is on the cusp of doing so. Add the looming threat of a no deal Brexit to the equation, and these are uncertain times.

Working out which way the global economy will tip is no mean feat, with countless indicators of growth and economic prospects creating a huge web of analysis prospects.

According to Neil Shearing, the group chief economist at research house Capital Economics, one set of indicators is more important than any other right now: those which track financial conditions.

In a blog titled 'If you only watch one chart, make sure its this one,' Shearling argues that financial conditions indicators, which a heap of macro variables such as interest rates, credit spreads, stock prices, and currency levels, are key for forecasting the future.

"Will the recent weakness in a broad swathe of economic data be a flash in the pan or does it herald the start of a new global downturn?" - Shearling asked. "The answer is likely to depend in part on what happens to financial conditions."

Financial conditions are a good indicator of future macroeconomic changes, Shearling argues, for two key reasons:

  • First, financial conditions indices (FCIs) across all the world's major economies tend to move in sync. This is particularly true with the US and Europe, Shearling adds. "It's rare that financial conditions in one major economy tighten without there being a similar tightening in the others," he writes.
  • Secondly, if financial conditions tighten sharply, it tends to indicate a coming slowdown, meaning that there is no need to focus on a specific level for the indicator. "We should therefore put more emphasis on changes in our financial conditions indicators rather than their level," Shearling said.

"What happens to financial conditions next will have a significant bearing on the prospects for economic growth this year," Shearling continues.

"If the recent stabilization is a sign of things to come then it becomes easier to believe that the weakness in the latest economic data will be a flash in the pan.

"By contrast, if financial conditions start to tighten once again (and our sense is that they probably will) then we're likely to feel the consequences in terms of a further slowdown in growth over the coming quarters.

"Either way," he concludes: "This is the chart to watch over the coming months."

You can see it below:

Capital Economics

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