Profiting from the economic cycle using the Investment Clock

Forecasting future asset class returns are, needless to say, challenging. To do so effectively requires, among other things, a clear picture of your starting point. Where are we in the cycle ? What is the timing for increased inflation? To generate profits for clients one must be able to model in real time when the world economy moves from one phase in the cycle to another.

The Investment Clock approach recognises different points within the economic cycle and differentiates between phases which are likely to generate growth and inflation readings based on past trends and the current momentum of lead indicators. These indicators are updated on a monthly basis to build an expectation of how the global economy may perform over the coming three to six months.

The growth reading sets the relative weighting of cyclical and defensive assets (North-South on the clock diagram). The inflation reading sets the weighting of financial assets versus real assets (East-West).

Time lags in the release of economic data mean it reflects what has already happened in the economy. However, to profit we need to recognise in real time when the world economy moves from one Investment Clock phase to another. Therefore, we need a “now-cast” of each possible economic growth and inflation outcome, growth and inflation being the two key mPublish Posteasures of economic activity. To build this now-cast, we consider an array of trend indicators, leading indicators and price signals from the markets themselves. This now-cast drives fund positioning on a real time basis.

With the benefit of hindsight we can identify the historic phases of the US economic cycle by taking note of the major peaks and troughs in the growth and inflation cycles.

Based on back testing, some asset classes perform better than others in each phase: the Investment Clock links the phases of the economic cycles to the performance of the asset classes:



The Investment Clock below shows the four key stages of an economic cycle:

• Stagflation (like we saw in mid-2008). A difficult time for most markets where growth has moved below trend but inflation concerns are high. As the Clock shows, we believe this is a period where Cash can outperform most other investments.

• Reflation (July 2008-March 2009). Often characterised by a period of interest rate cuts, we believe this is often a period of the cycle when bonds can perform well.

• Recovery (such as that which has been experienced through the summer of 2009). Often follows a period of reflation and can represent the best conditions for stocks to perform well; improving growth with falling inflation.

• Overheat (where we believe we were headed in Q4 2009 and into Q1 2010). Typically when commodities tend to shine through as the prospect of inflation rises are coupled with growth above trend.




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