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Why investors can use loan default rates to predict a recovery

Why investors can use loan default rates to predict a recovery (Part 1 of 4)

Why leading indicators and the default rate help predict recovery

Economic recovery

Economy recovery is, simply enough, when the economy recovers from a recession. Signs of an economic recovery include rising gross domestic product (or GDP), controlled lower inflation, declining unemployment, increased activity in the financial markets, and declining loan defaults.

These indicators are categorized as leading or lagging indicators based on when they show signs of recovery in the economy.

Civilian unemployement rate & the S&P 500 indexEnlarge Graph

As we can see in the chart above, leading indicators such as stock market indices—the S&P 500 Index (SPY), in this case—react ahead of an economic recovery, as they’re largely driven by investors’ expectations about the future. Other indicators, such as unemployment—the civilian unemployment rate, in this case—take time to react, as employers take time to build confidence in the market and start hiring. In the chart above, the S&P 500 Index falls rapidly all through 2008 up to 2009, signaling an economic recession. It’s during this period that even the iShares S&P 100 ETF (OEF), which is a large cap equity fund with holdings in blue chip companies like Apple Inc. (AAPL) and Exxon Mobil Corporation (XOM), saw a price decline of almost 55% (from October 1, 2007 to March 02, 2009). The credit crises of 2008 also affected the likes of the popular iShares Core Total US Bond Market ETF (AGG), which saw a price decline of 14.52%, and the Vanguard REIT Index ETF (VNQ), which saw its price plummet by 68.96%, during that period.

The civilian unemployment rate, on the other hand, rises steadily until October 2009, and only after then starts to show signs of recovery.

Similarly, declining loan defaults signal a recovering economy. This one is more of a lagging indicator, as it’s during the recovery phase of the economy that economic activity increases, leading to increases in money flows and leaving people in a better position to service their loan obligations. In a recessionary economy, more and more people default on their loan obligations, as inflationary pressures squeeze disposable income. A popular measure of loan defaults is the default rate.

To learn more about the relationship between default rates and bond prices, see the Market Realist series What is the default rate and how it relates to bond and loan prices.

To see how default rates relate to economic recovery, read on to the next part of this series.

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