THE

INVESTMENT
CLOCK
 North Korea’s sixth nuclear test and the world’s
response
Fed Cuts Interest Rates Amid Economic Uncertainty

 Damage assessment and rebuilding following

Hurricane Harvey and now Hurricane Irma

Saudi oil attack roils global energy markets

Investment Clock

is an intuitive way of relating asset rotation

and sector strategy to the economic cycle. The
Investment Clock model splits the economic
cycle into four phases depending on the
direction of growth relative to trend and the
direction of inflation
How to use the Investment Clock

• ML’s Investment Clock splits the economic cycle

into four separate phases, depending on the
direction of growth relative to trend, i.e. the
“output gap”, and the direction of inflation. In
each phase, the assets and equity sectors shown
in the diagram (Chart 1) tend to outperform
while those in the opposite corner tend to
underperform.
• The classic boom-bust cycle starts at the bottom
left and moves around clockwise with Bonds,
Stocks, Commodities and Cash outperforming in
turn. Life is not always so simple. Sometimes the
clock moves backwards or skips a phase. We will
be making judgements on the future stage of the
global economic cycle in our asset allocation
research.
 Reflation is a form of

Each phase of the economic cycle is associated with a policy enacted after a
period of economic

specific asset class slowdown. Policies

include infrastructure
spending and cutting
tax and interest rates.

I. In Reflation, GDP growth is sluggish (This phase occurs during the heart of a bear
market). Excess capacity and falling commodity prices drive inflation lower. Profits
are weak and real yields drop. Yield curves shift downwards and steepen as central
banks cut short rates in an attempt to get the economy back onto its sustainable
growth path. Bonds are the best asset class.

II. In Recovery, policy ease takes effect and GDP growth accelerates to an above trend
rate. However, inflation continues to fall because spare capacity has not yet been
used up and cyclical productivity growth is strong. Profits recover sharply but central
banks keep policy loose and bond yields stay low. This is the “sweet spot” of the
cycle for equity investors. Stocks are the best asset class.
 In economics, stagflation, or

Each phase of the economic cycle is associated with a recession-inflation, is a

situation in which the

specific asset class inflation rate is high, the

economic growth rate
slows, and unemployment
remains steadily high

III. In Overheat, productivity growth slows, capacity constraints come to the fore and inflation
rises. Central banks hike rates to bring the economy back down to its sustainable growth
path, but GDP growth remains stubbornly above trend. Bonds do badly as yield curves shift
upwards and flatten. Stock returns depend on a trade-off between strong profits growth
and the valuation de-rating that often accompanies a sell-off in bonds. Commodities are the
best asset class.
IV. In Stagflation, GDP growth slows below trend but inflation keeps rising, often due in part
to oil shocks. Productivity slumps and a wage-price spiral develops as companies raise
prices to protect their margins. Only a sharp rise in unemployment can break the vicious
circle. Central banks are reluctant to ease until inflation peaks, limiting the scope for bonds
to rally. Stocks do very badly as profits implode. Cash is the best asset class.
Growth and inflation drive the Clock
• 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.
Growth and inflation drive the Clock
• 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 pricesensitive, doing well in the Reflation
or Recovery phases. Mining stocks are metal
price-sensitive, doing well during an Overheat.
Oil & Gas is sensitive to the oil price,
outperforming in bouts of Stagflation
Growth and inflation drive the Clock

The Opposites Make Sense

Lastly, the opposites are
meaningful and can generate useful
pair trade ideas. For example, if we
are in the Overheat phase we
should be long Commodities and
Industrial stocks. The consistent short
positions would be Reflation plays in
the opposite corner: Bonds and
Financials
THANK YOU!
FINANCIAL
REPRESSION
 FINANCIAL REPRESSION
DEFINITION

simply refer to existence of ceilings on deposit and/or lending rates

refer to governments’ intervention in the price formation in financial

markets with various other tools.
 WHY GOVERNMENTS WOULD OPT FOR
FINANCIAL REPRESSION POLICIES

‘Most developing countries slipped into financial

repression inadvertently; the original policy was aimed
simply at financial restriction.’

‘Financial restriction encourages institutions and financial instruments

from which government can appropriate a large seignorage and
discourages all others.

‘Selective or sectoral credit policies are common components of financial restriction.

… The former necessitates the latter. For selective credit policies to work at all,
financial markets must be kept segmented and restricted.’
 WHY GOVERNMENTS WOULD OPT FOR
FINANCIAL REPRESSION POLICIES

‘Most developing countries slipped into financial

repression inadvertently; the original policy was aimed
simply at financial restriction.’

‘Financial restriction encourages institutions and financial instruments

from which government can appropriate a large seignorage and
discourages all others.

‘Selective or sectoral credit policies are common components of financial restriction.

… The former necessitates the latter. For selective credit policies to work at all,
financial markets must be kept segmented and restricted.’
MECHANISM
Financial repression consists of the following
• Explicit or indirect capping of interest rates, such as on government debt and
deposit rates.
• Government ownership or control of domestic banks and financial institutions
with barriers that limit other institutions from entering the market.
• High reserve requirements.
• Creation or maintenance of a captive domestic market for government debt,
achieved by requiring banks to hold government debt via capital
requirements, or by prohibiting or disincentivising alternatives.
• Government restrictions on the transfer of assets abroad through the
imposition of capital controls.
BENEFITS
• By limiting the advantages of existing wealth, it lessens inequality
and increases social mobility.
• By forcing investors to buy bonds at rates below inflation,
financial repression subsidizes investment, which inevitably
stimulates growth. Poor nations from Russia to Japan to China
have repeatedly used negative real rates to encourage real
investment, build infrastructure, and so develop their economies.
CONSEQUENCES

1) Mal-investment.
Entrepreneurs are led to believe that the conditions are ripe for risky
ventures; it's much easier for a business to survive when paying 1.5%
than 6% on its debt. When these unsustainably low rates change,
businesses fail.
2) Consumer credit explosion.
Since the 1970s, real wages have been stagnant. In order to
accommodate a steadily rising standard of living ("American
Dream"), consumers bought on credit.
CONSEQUENCES

3) Increased risk / overvaluation.

Investors and financial institutions are incentivized to invest in riskier
assets. We are seeing this right now with dividend-paying equities
and risky debt securities like municipal bonds and junk debt.
CONSEQUENCES

4) Suffocation.
Some types of investors depend on interest from fixed income. These
include pensioners, retired people, university endowments, sovereign
wealth funds, insurance companies, and anyone that has a need for
low volatility, liquid assets and/or considerable cash on hand. Some
funds, realizing the negative real yields of treasuries, gilts, bunds,
etc., have been diversifying into land, dividend-paying equities, and
commodities.
CONSEQUENCES

5) Finally, and receiving the most fanfare, is runaway currency devaluation.

Many investors fail to grasp how money is created: under this system of
"modern money mechanics," central banks create currency and exchange it
with the Treasury for interest-bearing bonds. In order to lower bond rates, the
central bank must (through private banks and primary conduits) buy already-
issued bonds from the open market, raising the price and lowing the yield.
(The central bank can also collude with Treasury and primary dealers at
auction).
THANK YOU