The investment clock theory proposed by Merrill Lynch is a practical tool to guide investment cycles. By combining economic growth and inflation indicators, it divides the economic cycle into four stages – recession, recovery, overheating, and stagflation. In each stage, a certain type of asset will outperform others. Understanding the logic behind the investment clock provides insights on how to rotate between different assets based on macroeconomic conditions. This theory has practical significance for investment asset allocation in China, but also needs to be adapted to China’s actual national conditions.
Investment Clock Depicts Four Phases of Economic Cycle
The investment clock theory divides the economic cycle into four stages based on GDP growth and inflation rate: recession, recovery, overheating, and stagflation. In a recession, GDP declines and inflation is low. Bonds perform the best as monetary policy is loose. In a recovery, GDP rebounds while inflation stays low. Stocks outperform as corporate earnings improves. In an overheating economy, GDP growth is high but inflation picks up. Commodities do well as inflation hedges. In stagflation, GDP growth slows but high inflation persists due to supply shocks. Cash is king as tight monetary policy hurts financial assets.
Each Stage Favors a Certain Type of Asset
The investment clock shows which asset class tends to outperform in each economic phase. In recessions, bonds generate stable income. In recovery, economically sensitive stocks benefit from acceleration in growth. In overheating economies, commodities like oil, metals and agricultural products serve as inflation hedges. In stagflation, cash provides liquidity and preserves principal. As the economy cycles through these four stages, assets take turns outperforming in a clockwise rotation.
Adapting Investment Clock to China’s Economic Conditions
The investment clock shows regular economic fluctuations in developed markets. But China’s state-driven, investment-led growth model means policies outweigh cycles. China tends to skip recession and spend more time in overheating due to stimulus policies that lift growth at the cost of efficiency. Moreover, CPI lags real activity so high inflation persists after growth peaks. Therefore, the investment clock needs to be adapted with money supply and credit growth as key indicators of China’s cycle.
Rotation Between Stocks, Bonds and Commodities Persists
Despite limitations, cyclical rotation between stocks, bonds and commodities persists in China. State-owned enterprise reforms benefit stocks early in recovery while infrastructure spending aids commodities in overheating economies. Tighter policy hurts stocks and commodities while spurring bonds. The investment clock reminds investors to align holdings with the economic cycle and not get carried away by sentiment during specific phases.
The investment clock theory analyzes the interplay between the economic cycle and financial assets. Though policy effects need to be considered, its framework of cyclical rotation provides useful insights for asset allocation in China. Investors should combine top-down and bottom-up approaches, leveraging macro analysis and stock picking.