statistical trends go neg– business confidence is a leading indicator of growth

Business confidence is a well-known leading indicator of future output, especially during economic downturns, and receives attention from the media, policymakers and forecasters. Somewhat surprisingly, the direct link between business confidence and investment has not yet been investigated. Our paper fills this gap. We provide a quantitative assessment of the information in business confidence for future investment growth, after controlling for the conventional determinants such as user cost, output, cash flow and stock price. Understanding the predictive power of business confidence is valuable along three dimensions. First, it can help forecasters and policymakers improve their investment forecasts. Second, it can provide a rationale for explicitly including business confidence– either as causal or as anticipatory– in theoretical models of business cycles. Third, it can help motivate studies on the how investment managers’ social and psychological circumstances influence investment decisions over and beyond rational cost-benefit analyses.1 We consider the Organization for Economic Co-Operation and Development (OECD)’s business confidence index for the US as a measure of business confidence and ask the following three questions.2 Does business confidence have independent information about future business investment growth? Does it have forecasting power for investment downturns? Does it help in making directional forecasts– the positive or negative movements in the trajectory of investment growth? Previous literature that used business confidence has primarily studied its predictive properties for variables other than investment. Heye (1993) examines the relationship between business confidence and labour market conditions in the US and other industrialized countries. Dasgupta and Lahiri (1993) show that business sentiments have explanatory power of forecasting business cycle turning points. Taylor and McNabb (2007) find that business confidence is procyclical and plays an important role in forecasting output downturns. Although we focus on business confidence, our paper is related to a large body of previous research that has studied consumer confidence or sentiment and its ability to forecast macroeconomic variables. Leeper (1992) finds that consumer sentiment does not help predict industrial production and unemployment, especially when financial variables are taken into account. On the other hand, Matsusaka and Sbordone (1995) reject the hypothesis that consumer sentiment does not predict output. Carroll, Fuhrer and Wilcox (1994), Fuhrer (1993), Bram and Ludvigson (1998), Ludvigson (2004) and Cotsomitis and Kwan (2006) find that the consumer attitudes have some additional information about predicting household spending behaviour. Lahiri, Monokroussos and Zhao (2016) employ a large real-time dataset and find that the consumer confidence survey has important role in improving the accuracy of consumption forecasts. Christiansen, Eriksen and Møller (2014) find that consumer and business sentiments contain independent information for forecasting business cycles. Barsky and Sims (2012) find that consumer confidence reflects news about future fundamentals and a confidence shock has a persistent effect on the economy. More recently, Angeletos, Collard and Dellas (2018) quantify the role of confidence for business cycle from both theoretical and empirical perspectives. They construct a measure of confidence within a Vector Autoregressive (VAR) framework by taking the linear combination of the VAR residuals that maximizes the sum of the volatilities of hours and investment at frequencies of 6 to 32 quarters. Their measure likely captures a mixture of consumer and business confidence and is, therefore, distinct from the survey-based measure that we use in our analysis. We find that business confidence leads US business investment growth by one quarter. It leads structures investment, which is one of the major components of business investment, by two quarters. Our empirical analysis shows that investors’ confidence has statistically significant predictive power for US business investment growth and its components (equipment and non-residential structures) after controlling for other determinants of investment. To better gauge the role of business confidence for investment growth, we also perform Out-Of-Sample (OOS) test for 1990Q1–2016Q4. Our findings suggest that the OOS test results are similar to the in-sample test results.3 While, as we found, business confidence has predictive power for total investment, it may also contain additional information on the trajectory of investment as captured by downturns and directional changes. This information would be of interest to policymakers in assessing the economy’s near-term outlook, over and above the general ability of business confidence to forecast investment. Indeed, we find that contemporaneous correlation between business confidence and investment growth rises during NBER recession dates. This property of the data suggests that it is worthwhile to explore the forecasting ability of business confidence for investment downturns and directional changes. Towards this end, we define investment downturns as business investment growth below the sample average for more than two consecutive quarters.4 Using a static probit forecasting model, we assess the OOS forecasting ability of business confidence for investment downturns for 1990Q1–2016Q4. A key finding of this approach in the literature is that term spread and stock price contain information for forecasting US recessions (Estrella and Mishkin (1998); Nyberg (2010); Kauppi and Saikkonen (2008)). We follow a similar approach and find that business confidence has statistically significant forecasting power for investment downturns over 1–4 quarter forecast horizons in the US economy. It has stronger forecasting ability than the traditional predictors such as term spread, credit spread and stock price at 1–3 quarter forecast horizons. We also find strong evidence that the business confidence has good incremental predictive power for investment downturns over 1–4 quarter forecast horizons, controlling for other predictors of downturns. Next, we evaluate the forecasting ability of business confidence for the direction of investment growth.5 Using a static probit forecasting model, we find that business confidence has statistically significant OOS forecasting ability for direction of investment growth at 1–3 quarter forecast horizons. Remarkably, it exhibits superior forecasting performance for 2–quarter forecast horizon than other predictors, such as, stock price, term spread and credit spread. When we control for other predictors in the forecasting model, we find that business confidence has incremental forecasting power for the direction of investment growth for shorter forecast horizons. Finally, we evaluate if the information in business confidence reflects either non-fundamental factors like ‘animal spirits’ or news about future fundamentals. We follow a VAR model approach similar to Barsky and Sims (2012) for consumer confidence, and evaluate the dynamic behaviour of different components of investment growth to a surprise increase in investor’s confidence. A positive business confidence shock increases US business investment growth on impact, followed by a hump-shaped response for shorter (5-6 quarter) horizons. This response is also statistically significant. This finding suggests that business confidence innovations clearly convey important information about the future paths of investment growth, most notably at shorter horizons. Since the effects dissipate within about two years, it is likely that the information in business confidence reflects primarily non-fundamental factors. This conclusion follows the interpretation in Barsky and Sims (2012). Interestingly, they find that effects of consumer confidence shocks on non-durable consumption are persistent and capture changes in expected productivity (future fundamentals). By contrast, we find that the effects of business confidence shocks on investment are relatively transient and likely reflect short-lived ‘animal spirits’.