Different economic cycles lead to different approaches to asset classes.
Investment professionals have used the concept of an investment clock for many years to determine which asset classes perform best at different stages of the global business cycle and changes in interest rates. With the hand now pointing to an economic and equity market recovery, time is running out for investors? Is the growing concern about inflationary pressures and possible interest rate hikes justified? Should we lower our expectations for financial market performance? And most importantly, how should we position the portfolios given the current state of the investment clock?
When United States Secretary of the Treasury Janet Yellen earlier this month raised the possibility of interest rate hikes to contain inflation, financial markets went into turmoil, especially tech stocks. top rated under heavy pressure. While Yellen quickly played down her comments, saying she did not anticipate a rate hike, markets remained somewhat volatile.
Investor worries about inflation data that could push up interest rates – which had been climbing for some time before the comments of the former U.S. Federal Reserve chairman – can perhaps best be explained by looking at the so-called investment clock – a concept used by investment experts since its first version was published by a London evening newspaper in 1937.
Essentially, the clock combines the changes in the dynamics of economic growth and the rise and fall of short-term interest rates to divide the investment environment into four phases or quadrants, as can be seen in the figure. .
It is important to note that the clock moves counterclockwise. We’re starting to follow the clock as economic momentum (a movement to the right on the x-axis on the chart) picks up after a recession (quadrant three), but interest rates are still low. As we move into the recovery phase (quadrant four), economic activity picks up beyond the recession and activity levels accelerate, while interest rates remain low.
When economic activity picks up and pressure points develop, economic authorities begin to step in by raising interest rates to address those pressure points, pushing us into the first quadrant. Of course, then the economic momentum begins to slow down, and we may even fall back into the recession phase before central banks cut rates in response, and the cycle begins again.
Asset classes and sectors
Where the clock becomes interesting and useful for investment purposes is that asset classes – and sectors within asset classes – tend to display different patterns of behavior in each phase or quadrant of the cycle. Historically, equities have outperformed all other asset classes in the recovery and mid-cycle phases (between the fourth and the first quadrant). When economic activity begins to run out of steam, inflation begins to become a threat and interest rates begin to rise, defensive assets such as bonds, especially inflation-linked bonds, gold and even cash is doing relatively well.
An accurate understanding of the current state of the investment clock is therefore essential for investors when deciding on asset allocation. “Keeping the clock” is of course the tricky part – even seasoned investment professionals often have a hard time figuring out where we are in the investment cycle.
A year ago, we were clearly in a recession, in an environment of very low interest rates. However, due to the very aggressive policy responses from the economic authorities, we have now entered strongly into the recovery phase, and many analysts agree that we are in fact close to the edge of the cyclical growth quadrant (the brown dot on the graph).
In terms of asset classes, historical trends have certainly been confirmed. The recovery in equity markets, both global and local, has been nothing short of remarkable over the past year. Within this asset class, cyclical counters and high value stocks tend to perform well in the recovery phase, and we have seen this in the performance of some of the oil majors, as well as banks in the recovery phase. the world. Closer to home, we have seen a significant recovery in commodity prices.
Given our current view of the investment clock, what are the asset classes and sectors we should focus on to appropriately balance a multi-asset class portfolio? As we approach the cyclical growth phase, which assets are likely to perform best both at the dawn and early stages of this phase? Based on our own research, analysts at Sanlam Private Wealth have determined the average monthly returns of various asset classes in each of the four phases since 1995:
As the table shows, within global equities, cyclical stocks such as financials, mining and tech stocks should continue to offer relatively higher returns in an environment where we still see strong economic growth and where policymakers do not. ‘have not yet raised rates. South African stocks in general should also hold up well to the entry of the first quadrant. We will therefore favor these asset classes and sectors when we consider the asset allocation of our clients’ portfolios.
In this context, it would be premature to increase exposure to defensive assets such as global bonds or this still controversial asset, gold. We are well aware that the next phase of the cycle will introduce more risk into the macro environment, and the current clock reading carries more risk compared to the previous phase.
One of those risks is growing concern about global inflation and the possibility that central banks will start to tighten the screws, which could well lead to slower growth or even recessionary conditions. Although near-term inflationary pressures are starting to intensify globally, we believe that key rates are unlikely to rise in the United States or Europe before the end of the year. Economic authorities around the world have so far given all indications that they have no intention of derailing the economic recovery by prematurely raising rates.
Of greater concern is whether inflation can become a structural problem, resulting from bottlenecks in the supply and demand system. In the United States, the average inflation rate since 2000 has hovered around the Federal Reserve’s 2% target, but is now exceeding that figure. Is this a “transitory” phenomenon, as the Fed has tried to point out?
Perhaps the best way to determine what might happen to inflation is to look at market expectations in the United States – the five-year average expectation of the inflation rate is 2.7%, but for the next 10 years the figure is 2.4%. If long-term inflation expectations are lower than short-term ones, it probably means that there are short-term bottlenecks that should be smoothed out over time. In our view, while current inflationary pressures may discourage market optimism to some extent, they certainly should not affect the long-term outlook for equity markets.
The interpretation of the investment clock is important, but unlike those of a Swiss watch, its mechanics are not always associated with the same predictability. We cannot just assume that history will repeat itself and that certain asset classes or sectors will always do well in a particular phase of the cycle. So we place a valuation overlay on the investment clock – as value investors, we also need to be able to justify holding assets from a price perspective.
Due to the dramatic rally in the capital value of cyclical stocks such as mining, banking and tech over the past year, the valuations of some of these stocks are starting to look strained. They did a remarkable run, with stunning performances on the scoreboard, but that, in our opinion, narrowed the track for further momentum.
The expected returns of these stocks over the next 12 months are therefore likely to be lower than the phenomenal nominal returns we have seen since the March 2020 lows. We certainly believe that there is still enough lead to favor these sectors and South African stocks generally in our clients’ multi-asset portfolios – they are likely to continue to perform well in the cyclical growth phase. Now is certainly not the time to be anything but underweight global bonds and cash. However, due to our valuation bias, we believe we should lower our expectations for potential returns in these equity sectors over the next year.
One last word
The investment clock does not run rhythmically like the trust watch on your wrist. A shift from one quadrant or phase to another can happen very quickly and unexpectedly, as we saw in March of last year. Markets are forward looking, and as investment managers we need to make sure we get a head start and adjust our clients’ portfolios before moving on to the next phase of the cycle.
At some point, higher interest rates – or even just talk about rate hikes – are likely to impact the rating of the equity sectors we favor. If the very good performance of these sectors continues, we can therefore take some profits and reduce our clients’ exposure to these assets. In other words, when we believe that the prices of certain assets fully reflect the fundamentals associated with the particular quadrant, we will begin to exit those assets and position our clients’ portfolios for the next phase.
Alwyn van der Merwe is the Director of Investments at Sanlam Private Wealth.