Different economic cycles makes for different approaches to asset classes.
Investment professionals have for many years employed the concept of an investment clock to determine which asset classes perform best in the various stages of the global economic cycle and interest rate changes. While the hand is currently pointing to economic and equity market recovery, is the clock ticking for investors? Is the mounting concern over inflationary pressures and possible interest rate increases justified? Should we reduce our financial market return expectations? And importantly, how should we position portfolios given the current status of the investment clock?
When US Treasury Secretary Janet Yellen earlier this month pointed to the possibility of interest rate hikes in order to keep inflation at bay, financial markets went into a flurry, with especially the higher-rated technology shares coming under severe pressure. While Yellen quickly downplayed her remarks, saying she wasn’t forecasting rate hikes, markets have remained somewhat unsettled.
Investor concerns over inflation data potentially driving up interest rates – which had been mounting for some time before the former US Federal Reserve chair’s comments – can perhaps best be explained by looking at what’s known as the investment clock – a concept that’s been in use by investment experts since the first version of it was published by a London evening newspaper in 1937.
Essentially, the clock combines changes in economic growth momentum and the rise and fall of short-term interest rates to divide the investment environment into four phases or quadrants, as can be seen on the figure.
It’s important to note that the clock moves in an anticlockwise direction. We start to follow the clock as economic momentum (a move to the right on the x-axis on the graph) recovers following a recession (quadrant three), but interest rates are still low. When advancing into the recovery phase (quadrant four), economic activity recovers beyond the recession and activity levels gain momentum, while interest rates remain low.
When economic activity accelerates and pressure points develop, economic authorities start to interfere by hiking interest rates to address these pressure points, pushing us into the first quadrant. Of course, economic momentum then starts to slow, and we can even sink back into the recession phase before central banks drop rates in response, and the cycle starts again.
Asset classes and sectors
Where the clock gets interesting and useful for investment purposes, is that asset classes – and sectors within asset classes – tend to display different behaviour patterns 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 first quadrant). When economic activity starts to lose momentum, inflation starts to become a threat and interest rates start rising, defensive assets such as bonds, especially inflation-linked bonds, gold and even cash do relatively well.
An accurate understanding of the current status of the investment clock is therefore essential for investors when deciding on asset allocation. “Telling the time” is of course the tricky part – even seasoned investment professionals often struggle to pinpoint where we are in the investment cycle.
A year ago, we were clearly in a recession, in a very low interest rate environment. As a result of highly aggressive policy responses by economic authorities, however, we’ve now moved strongly into the recovery phase, and many analysts would concur that we’re in fact close to the cusp of the cyclical growth quadrant (the brown dot on the graph).
In terms of asset classes, the historical trends have certainly been borne out. The recovery in the equity markets, both global and local, has been nothing short of remarkable over the past year. Within this asset class, cyclical counters and deep value shares tend to do well in the recovery phase, and we’ve seen this in the performance of some of the oil majors, as well as banks globally. Closer to home, we’ve seen a material recovery in commodity prices.
Given our current view on the investment clock, what are the asset classes and sectors we should be focusing on to appropriately balance a multi-asset class portfolio? If we’re edging towards the cyclical growth phase, which assets are likely to perform the best both on the cusp and going into this phase? Based on our own research, the Sanlam Private Wealth analysts 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 shares such as financial, mining and technology are likely to continue to provide relatively stronger returns going into an environment where we are still seeing strong economic growth and with policymakers yet to hike rates. South African equities in general should also hold up well going into the first quadrant. We’ll therefore be favouring these asset classes and sectors when we consider asset allocation for our clients’ portfolios.
In this context it would be premature to increase exposure to defensive assets such as global bonds or even that ever-controversial asset, gold. We’re well aware that the next phase of the cycle will introduce more risk in the macro environment, and that the current reading of the clock has more risks associated with it relative to the preceding phase.
One of these risks is the growing concern regarding global inflation and the possibility that central banks will start tightening the screw, which may well result in slowing growth or even recessionary conditions. Although short-term inflationary pressures globally are starting to build, our view is that it is unlikely that policy rates will increase in the US or Europe before the end of the year. Economic authorities worldwide have so far given every indication that they in no way intend to derail economic recovery by hiking rates prematurely.
Of greater concern is whether inflation may become a structural issue, resulting from bottlenecks in the system of demand and supply. In the US, the average inflation rate has since 2000 hovered around the Federal Reserve’s target of 2%, but it has now surpassed this figure. Is this a ‘transitory’ phenomenon, as the Fed has been at pains to point out?
Perhaps the best way to determine what might happen to inflation is by looking at market-based expectations in the US – the average five-year inflation rate expectation is 2.7%, but for the next 10 years, the figure is 2.4%. If the longer-term inflation expectations are lower than those over the shorter term, it probably means there are short-term bottlenecks that should be smoothed out over time. In our view, while the current inflationary pressures may deter market optimism to some extent, they certainly shouldn’t impact the longer-term prospects of the 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 amount of predictability. We can’t 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. We therefore place a valuation overlay onto the investment clock – as value-based investors, we also need to be able to justify holding assets from a price perspective.
As a result of the very strong recovery in the capital value of cyclical shares such as mining, banks and technology over the past year, the valuations of some of these shares are starting to look stretched. They’ve had a remarkable run, with some stunning performances on the scoreboard, but this has, in our view, reduced the runway for a continuation of the momentum.
The expected returns of these shares over the next 12 months are therefore likely to be lower than the phenomenal nominal returns we’ve witnessed since the lows of March 2020. We certainly believe there’s still enough runway left to favour these sectors and South African equities in general in our clients’ multi-asset portfolios – they’re likely to continue to do well going into the cyclical growth phase. It’s also definitely not the time to be anything but underweight in global bonds and cash. However, as a result of our valuation bias, we believe we should be dialling down our expectations for prospective returns in these equity sectors over the next year.
A last word
The investment clock does not rhythmically tick away like the trusted timepiece on your wrist. A shift from one quadrant or phase to the next can happen very rapidly and unexpectedly, as we saw in March last year. Markets are forward-looking, and as investment managers, we need to ensure we’re ahead of the clock hand and adjust our clients’ portfolios before a potential move to the next phase in the cycle.
At some point, higher interest rates – or even just talk of rate hikes – are likely to have an impact on the rating of the equity sectors that we favour. If there is a continuation of the very strong performance of these sectors, we may therefore take some profits and reduce our clients’ exposure to these assets. In other words, when we think that the prices of certain assets fully reflect the fundamentals associated with the particular quadrant, we’ll start to move out of these assets and position our clients’ portfolios for the next phase.
Alwyn van der Merwe is the director of investments at Sanlam Private Wealth.