Sharp recovery coming? Here’s an index I’ll be watching very closely

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The Canadian economy is mired in a second quarter that TD economist David Tulk all-but guaranteed would be "ugly" once all the data are in. Economists, however, expect a sharp recovery in the second half of 2016 with third-quarter growth of 2.5 per cent and a fourth-quarter expansion of 2.0 per cent.

Investor returns for the year will depend in large part on the extent to which the lofty second-half expectations are met. The Citi Economic Surprise index for Canada is likely the best means of measuring, in real time, whether the recovery is occurring.

The Citi Surprise index is not a measure of actual economic activity – it compares actual economic data reports to consensus expectations. The index falls when important economic reports like gross domestic product growth, retail sales and industrial production fall short of the average economist forecast.

The chart compares the performance of the S&P/TSX composite equity benchmark with the surprise index over the past two years. The relationship is not perfect over the full time period, but the S&P/TSX has closely tracked the surprise index since June of 2015, when the economic outlook became more uncertain.

Perhaps more importantly, the surprise index appears to be leading equity performance. This is particularly evident in the period of June to August, 2015. The surprise index also began to improve significantly on Jan. 12, 2016, eight days before the S&P/TSX composite began a 19-per-cent rally.

I don't, however, want to over-emphasize the surprise index as an equity market signal. It's providing a leading indicator now, and for stocks representing companies entirely focused on the domestic economy, the surprise index will likely continue to be useful. But as the chart shows, the surprise index was not much use to equity investors in late 2014 and early 2015.

There is so much riding on third-quarter growth that Canadians should pay close attention to the index when available. The current forecast for second-quarter growth is a mere 0.2 per cent, so even with the expected 2.5 per cent growth in the third quarter and 2.0 per cent in the fourth quarter, 2016 gross domestic product expansion is only expected at a mediocre 1.6 per cent for the year.

A sliding surprise index into September and October would suggest that current low expectations for the Canadian economy aren't pessimistic enough, and the 1.6-per-cent target for the year won't be met. More happily, a steadily rising surprise index would indicate a stronger-than-expected domestic recovery, and likely stronger equity markets.