Understanding Economic Regimes with the Investment Clock

Disclaimer: the information provided is purely educational and does not constitute investment recommendations. Before adopting any financial strategy it is essential to consult a qualified financial advisor.

Introduction and Objectives

The objective of this approach is to classify the phase of the economic cycle we are in by means of macroeconomic indicators and, consequently, to set an allocation across asset classes that historically maximized performance in each scenario. The methodology presented, inspired by Merrill Lynch’s Investment Clock, aims to provide a systematic and reproducible framework, supported by code (Google Colab), to carry out macro-financial analyses on your own.

The Theoretical Model: the Investment Clock

The Investment Clock model originates from the studies of Merrill Lynch and was later developed by Trevor Greetham of Royal London Asset Management. The idea is to represent the economic cycle on a dial with two axes: inflation on the horizontal axis and economic growth on the vertical axis. According to RLAM, the economy goes through periods of expansion and contraction, overheating and cooling, with inflation rising or falling; each phase favors different asset classes.

The phases are four:

• Reflation (Reflection) – weak growth and falling inflation (typical of a bear market phase).
• Recovery – accelerating growth and still low inflation (“Goldilocks”).
• Overheat – strong growth bumping into supply constraints, causing inflation to rise.
• Stagflation – slow/negative growth and high inflation (often preceded by energy shocks).

The Investment Clock diagram summarizes which asset classes and sectors tend to perform best in each phase, based on over four decades of historical data.

Preferred Asset Classes in Each Phase

According to an RLAM (2024) insight on “ClockWise”:

• Reflation – government bonds: better returns when growth is weak and inflation is falling.
• Recovery – stocks: perform best when growth is strong and inflation continues to fall.
• Overheat – commodities: record high returns when both growth and inflation are increasing.
• Stagflation – cash and again commodities: cash becomes the defensive choice while commodities can remain performing.

It is important to emphasize that these asset associations derive from historical observations and do not guarantee future results: markets are complex and correlations can vary. This allocation is a first simplified version that contemplates only 1 asset per economic regime. The difficulty of precisely defining when the economic regime changes and has led to more distributed versions over multiple assets.

Macro Indicators Used

Gross Domestic Product (GDP)

Nominal GDP measures the value of goods and services produced at current prices, while real GDP adjusts the figure for inflation. The IMF explains that, to determine real GDP, the nominal value must be adjusted with a price deflator: in this way it is possible to distinguish whether the increase in value derives from greater production or only from higher prices. The growth rate of real GDP is therefore a fundamental indicator for assessing the health of the economy.

Inflation and Consumer Price Index

The Consumer Price Index (CPI) measures the average changes in prices of a basket of goods and services; however, to better evaluate long-term trends, central banks use core inflation, which excludes the most volatile components (food and energy). The Federal Reserve notes that central bankers focus on core inflation, e.g. the core PCE deflator, because it removes temporary fluctuations and provides a clearer indication of the underlying trend. Concentrating monetary policy on core inflation helps avoid overreacting to temporary shocks; core inflation “tries to separate the signal from the noise,” providing a better picture of inflationary pressures and serving as a guide as to where headline inflation itself will head.

Recessions and the Business Cycle

In determining the phases of the cycle, our analysis considers a “recession” as a period in which real GDP records two consecutive quarters of contraction. However, it must be remembered that this is a convenient criterion: the St. Louis Fed explains that the National Bureau of Economic Research (NBER) uses various indicators (real income, employment, industrial production etc.) to officially declare a recession. It is still true, however, that “two negative quarters” are frequently associated with recessions.

Classification Method and Historical Results

The critical point concerns the definition of the conditions that define the economic phases. The technical recession is associated with “two negative quarters”. In our case, the economic phase is determined by evaluating both real GDP and core inflation to see if they are above or below certain thresholds. Clearly these become key parameters to define. In the transcript provided, 2.5% is adopted as the growth threshold and 3% as the inflation threshold: above these values one speaks of “high” growth/inflation, below of “low”. Crossing the two variables yields the four regimes (Reflation: low growth and low inflation; Recovery: high growth and low inflation; Overheat: high growth and high inflation; Stagflation: low growth and high inflation).

The historical analysis from 1947 to today (as indicated in the transcript) shows that:

• About 61% of the time real GDP growth was above 3% compared to the previous year.
• About 53% of the time inflation (core) was above 3%.
• The rarest phase turns out to be stagflation; followed by contraction and then, almost equally, recovery and overheat (~30–31% each).
• The recessions of the 1980s and the 2008 financial crisis fall into the Reflation phase (low growth, contained inflation), while recent years show a combination of high inflation and moderate growth similar, in terms of behavior, to the early 1980s.

Asset Allocation for Each Phase

An asset allocation scheme known in the Investment Clock world is that proposed by Corey Rittenhouse in the 1980s, taken up in various studies and then reworked by managers such as Ray Dalio (All Weather portfolio). The idea is to assign to each phase a combination of assets that historically maximized returns and minimized risk. In the four-asset version (stocks, bonds, commodities, cash), the weights are 100% when you are certain to be in that phase, as shown in the following table (Figure 2):

If you are uncertain of the scenario, you can assign a probability to each phase. For example, assuming the same probability (25%) for every scenario, you get a permanent portfolio with 25% in each asset (stocks, bonds, commodities, gold/cash). This approach is similar to the concept of Harry Browne’s permanent portfolio or Ray Dalio’s All Weather.

For greater diversification, Rittenhouse proposes a six-asset matrix (stocks, emerging market bonds, commodities, corporate bonds, Treasury bonds and inflation-linked bonds). In the following table (Figure 3), the rows represent assets, the columns the regimes, and the values express the percentage to invest if you are certain to be in that regime:

Final Considerations

• The Investment Clock model offers a framework to understand the position in the economic cycle and guide asset allocation.
• The use of real GDP and core inflation allows phases to be classified transparently.
• The sheets of Corey Rittenhouse (4 or 6 assets) show how to allocate the portfolio depending on the regime; combining the phases with probabilities yields a robust and balanced portfolio.

It must be emphasized that these associations derive from historical analysis and do not guarantee future results. Every investor should consider their time horizon, risk tolerance and consult a professional before implementing strategies based on these models.

Useful Links

• Colab Notebook (methodology): EconomicRegime.ipynb — Open on Google Colab
• YouTube Video: https://youtu.be/vxvqfH1qfuE

Main Sources

• RLAM “ClockWise” (assets per phase of the cycle) — rlam.com
• Definitions of real GDP and core inflation — imf.org · federalreserve.gov
• NBER recession criteria — stlouisfed.org