One of the most valuable mental models we use in our global macro research process is Merill Lynch’s Investment Clock. smart money dumb money.
The merrill lynch investment clock splits the business cycle into four phases Learn more about how it works and why it s important.
It’s a simple yet useful framework for understanding the various stages of a business cycle and which asset classes perform best in each stage. A similar framework is used at Bridgewater Associates, one of the most successful hedge funds of all time.
We’ll break down the Investment Clock and apply it to the current market to see which assets are likely to perform best going forward.
The Investment Clock Phases Explained:
The Investment Clock splits the business cycle into four phases. Each phase is comprised of the direction of growth and inflation relative to their trends. You can see these four phases in the chart below via Merrill Lynch.
Four Phases of Investment Clock
Here’s a breakdown of the four phases:
1) The Reflation Phase: Growth is sluggish and inflation is low. This phase occurs during the heart of a bear market. The economy is plagued by excess capacity and falling demand. This keeps commodity prices low and pulls down inflation. The yield curve steepens as the central bank lowers short-term rates in an attempt to stimulate growth and inflation. Bonds are the best asset class in this phase.
2) The Recovery Phase: The central bank’s easing takes effect and begins driving growth to above the trend rate. Though growth picks up, inflation remains low because there’s still excess capacity. Rising growth and low inflation is the goldilocks phase of every cycle. Stocks are the best asset class in this phase.
3) The Overheat Phase: Productivity growth slows and the GDP gap closes causing the economy to bump up against supply constraints. This causes inflation to rise. Rising inflation spurs the central bank to hikes rates. As a result, the yield curve begins flattening. With high growth and high inflation stocks still perform but not as well as in phase 2. Volatility returns as bond yields rise and stocks compete with higher yields for capital flows. In this phase, commodities are the best asset class.
4) The Stagflation Phase: GDP growth slows but inflation remains high (sidenote: most bear markets are preceded by a 100%+ increase in the price of oil which drives inflation up and causes central banks to tighten). Productivity dives and a wage-price spiral develops as companies raise prices to protect compressing margins. This goes on until there’s a sharp rise in unemployment which breaks the cycle. Central banks keep rates high until they reign in inflation. This causes the yield curve to invert. During this phase, cash is the best asset.
Reading The Investment Clock:
Below is a chart that illustrates the four phases of the Investment Clock together:
Here’s The Following From Merrill Lynch On Which Asset Classes Outperform During Each Investment Clock Phase:
Cyclicality: When growth is accelerating (North), Stocks and Commodities do well. Cyclical sectors like Tech or Steel out-perform. When growth is slowing (South), Bonds, Cash and defensives outperform.
Duration: When inflation is falling (West), discount rates drop and financial assets do well. Investors pay up for long duration Growth stocks. When inflation is rising (East), real assets like Commodities and Cash do best. Pricing power is plentiful and short-duration Value stocks outperform.
Interest Rate-Sensitives: Banks and Consumer Discretionary stocks are interest-rate sensitive “early cycle” performers, doing best in Reflation and Recovery when central banks are easing and growth is starting to recover.
Asset Plays: Some sectors are linked to the performance of an underlying asset. Insurance stocks and Investment Banks are often bond or equity price sensitive, doing well in the Reflation or Recovery phases. Mining stocks are metal price-sensitive, doing well during an Overheat.
Pretty simple, right?
Now let’s apply this framework to where we are today.
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