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Highlights of this Issue The Investment Clock ML’s Investment Clock is an intuitive way of relating asset rotation and sector strategy to the economic cycle. In this report we back-test the theory using more than thirty years of data. We find that, while every cycle has unique aspects, there are clear similarities that can help investors to make money. Methodology and Results 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 (Table 1). We use OECD “output gap” estimates and CPI inflation data to identify the historic phases in the U.S. since 1973. Then we calculate the average asset and sector returns for each phase, testing our results for statistical significance. We confirm that Bonds, Stocks, Commodities and Cash outperform in turn as the cycle progresses. We also find a very useful read-across to equity sector strategy and to the shape of the yield curve. See the diagram on the next page for a summary of the main results. Economic Cycle Analysis is Key We are not testing a real-time, quantitative trading rule. Rather, we are showing that a correct macro view ought to pay off in a particular way. It is striking how consistent the results are given that we pay no explicit attention to valuation, a factor often held to be of utmost importance. Economic cycle analysis, including an assessment of the aims and effectiveness of policy- makers, will form the core of our tactical asset allocation work. Based on this methodology, we still favour global “Overheat” plays: commodities, industrial stocks, Asian currencies, Japan and the emerging markets. We would underweight Government bonds, financials, consumer discretionary stocks and the U.S. dollar. See pages 17-20 for details. Table 1: The Four Phases of the Investment Clock Phase Growth* Inflation Best Asset Class Best Equity Sectors Yield Curve Slope I “Reflation” Ï Ï Bonds Defensive Growth Bull Steepening II “Recovery” Î Ï Stocks Cyclical Growth - III “Overheat” Î Î Commodities Cyclical Value Bear Flattening IV “Stagflation” Ï Î Cash Defensive Value - Source: ML Global Asset Allocation * Growth relative to trend (i.e. “output gap”) GLOBAL Contributors Trevor Greetham Director of Global Asset Allocation, Institutional Client Group (44) 20 7996 1535 Michael Hartnett Deputy Director of the RIC, Global Private Client Group (1) 212 449 5827 10 November 2004 The Investment Clock Special Report #1: Making Money from Macro Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 28. Global Securities Research & Economics Group Global Fundamental Equity Research DepartmentRC#60431501 The Investment Clock – 10 November 2004 Refer to important disclosures on page 28. 1. The Investment Clock in a Picture � 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. Chart 1: Asset and Sector Rotation over the Economic Cycle Te lec om s Industrials Utilities Fin an cia ls Te lec om s Industrials Utilities Fin an cia ls Info Tech & Basic Mats Pharm aceuticals&Consu me rS ta pl es Info Tech & Basic Mats Pharm aceuticals&Consu me rS ta pl es Oil & G as Con su m er Di sc re tio na ry Oil & G as Con su m er Di sc re tio na ry Stocks "Recovery" G ro w th R ec ov er s G ro w th R ec ov er s G ro w th W ea ke ns G ro w th W ea ke ns Inflation RisesInflation Rises Inflation FallsInflation Falls "Overheat" "Reflation" "Stagflation" Cyclical Growth Commodities Cyclical Value Bonds Defensive Growth Cash Defensive Value Source: ML Global Asset Allocation Team. Technical Note: We have tried to arrange things so the closer you are to the middle of the diagram, the stronger the statistical support from our back-testing. The model works best for broad asset rotation and explains some equity sectors (e.g. Consumer Discretionary, Oil & Gas) much more consistently than others (e.g. Telecoms, Utilities). The Investment Clock – 10 November 2004 Refer to important disclosures on page 28. 3 CONTENTS � Section Page The Investment Clock 1. A pictorial summary of our findings 2 How the Model Works 2. Explaining ML’s Investment Clock framework 4 Back-Testing Methodology 3. Using more than thirty years of U.S. data 7 Market Returns over the Cycle 4. Strong results for assets, equity sectors and fixed income; some intriguing patterns for foreign exchange and equity country strategy 10 Using the Investment Clock in Practice 5. Top-down cycle analysis should be the starting point for tactical asset allocation; we continue to favour global “Overheat” plays 17 Statistical Appendix I. Which results are robust and which aren’t 21 The authors would like to thank Magatte Wade for his help with the numerical work in this report. The Investment Clock – 10 November 2004 4 Refer to important disclosures on page 28. 2. How The Investment Clock Works ML’s Investment Clock is a way of relating the economic cycle to asset and sector rotation. In the first section of this report, we outline the thinking behind the model. � Long Run Growth and The Economic Cycle The long run rate of growth of an economy depends on the availability of the factors of production, labour and capital, and on improvements in productivity. In the short run, economies often deviate from their sustainable growth path and it is the job of policy-makers to get them back onto it. An economy operating below potential will suffer deflationary pressure and ultimately outright deflation. On the other hand, an economy consistently above its sustainable growth path will generate disruptive inflation. Recognising Turning Points Pays Off Financial markets consistently mistake these short-term deviations for changes in the long run trend rate of growth. As a result, assets become mispriced at the extremes of the cycle, just when corrective policy shifts are about to take effect. Investors correctly recognising the turning points can make money by switching into a different asset. Those extrapolating recent history lose out. For example, many investors bought expensive technology stocks in late 1999 on the grounds that the trend growth rate of the U.S. economy was increasing and these companies stood to gain most from this “New Era”. However, Fed tightening to counter a modest rise in inflation was already well advanced. The cycle peaked in early 2000 and the dot com bubble burst. The ensuing downturn prompted aggressive Fed ease to the enormous benefit of bonds and residential real estate. The Four Phases of the Cycle The Investment Clock framework helps investors to recognise the important turning points in the economy and identifies investments to take best advantage of a change. We split the economic cycle into four phases – Reflation, Recovery, Overheat and Stagflation. Each is uniquely defined by the direction of growth relative to trend, i.e. the “output gap”, and the direction of inflation. We believe that each of these phases is linked to the outperformance of a specific asset class: Bonds, Stocks, Commodities and then Cash (Chart 2). Chart 2: The Theoretical Economic Cycle – Output Gap and Inflation -1.1 -0.1 0.9 1 ���� ����� %21'6 672&.6 &2002',7,(6 &$6+ ���� �� ´5HIODWLRQ µ ´5HFRYHU\µ ´2YHUKHDWµ ´6WDJIODWLRQµ �� ��� ����������� ������� � Source: ML Global Asset Allocation Team. The horizontal line represents the “sustainable growth path”. Inflation lags growth, starting to rise only once spare capacity has been used up. It is very hard to identify changes in the long run trend and even harder to exploit them safely We divide the economic cycle into four phases, depending on the direction of the output gap and the direction of inflation The Investment Clock – 10 November 2004 Refer to important disclosures on page 28. 5 I. In Reflation, GDP growth is sluggish. 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. 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. � The Investment Clock The Investment Clock diagram is the same economic cycle re-drawn as a circle (Chart 3). A classic boom-bust cycle would start at the bottom left and move around clockwise. Transitions from one phase to the next are marked by the peaks and troughs in the output gap and inflation cycles. Chart 3: The Investment Clock &<&/,&$/ 9$/8( &2002',7,(6 &<&/,&$/ *52:7+ 672&.6 '()(16,9( *52:7+ %21'6 '()(16,9( 9$/8( &$6+ �� � �� �� � � �� � ������� ������� ´ 2YHUKHDW µ ´5HFRYHU\µ ´ 6WDJIODWLRQ µ ´ 5HIODWLRQ µ Inflation Troughs Inflation Peaks Output Gap Peaks Output Gap Troughs ������� ������� �� � �� �� �� �� �� Source: ML Global Asset Allocation Team. Arrows denote the sequence of phases in a classic boom-bust cycle. Each phase of the economic cycle is associated with a specific asset class The Investment Clock diagram is the same economic cycle, re- drawn as a circle The Investment Clock – 10 November 2004 6 Refer to important disclosures on page 28. Growth and inflation drive the Clock One advantage of drawing the cycle like this is that we can think about growth and inflation separately. Growth becomes North-South and inflation East-West. This helps us to understand market moves when overseas influences or shocks like “9/11” mean the cycle does not progress clockwise according to plan. The Clock helps with Equity Sector Strategy A second advantage is that it helps us think about sector strategy: • 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. • 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 price- sensitive, 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. 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. � In Summary ML’s Investment Clock links the four phases of the economic cycle to asset and sector rotation and to shifts in the bond yield curve (Table 2). The model makes the evolution of the growth and inflation cycles the key drivers of investment strategy. The rest of this report will test to see how well this theory has worked in practice. Table 2: The Four Phases of the Investment Clock Phase Growth* Inflation Best Asset Class Best Equity Sectors Yield Curve Slope I “Reflation” Ï Ï Bonds Defensive Growth Bull Steepening II “Recovery” Î Ï Stocks Cyclical Growth - III “Overheat” Î Î Commodities Cyclical Value Bear Flattening IV “Stagflation” Ï Î Cash Defensive Value - Source: ML Global Asset Allocation * Growth relative to trend (i.e. “output gap”) We can think about growth and inflation separately The clock opposites can generate useful pair trade ideas The growth and inflation cycles are the key drivers of asset and sector strategy in the Investment Clock model The Investment Clock – 10 November 2004 Refer to important disclosures on page 28. 7 3. Back-Testing Methodology We base our back-test of the Investment Clock on the U.S., where there are more than thirty years of good data for asset and sector returns. We first associate each calendar month with a phase of the Clock by looking at the interaction between the growth and inflation cycles. Then we group together all the months in a given phase and calculate the average returns from various investments, testing our results for statistical significance. � Peaks and Troughs in the Output Gap Cycle The output gap measures the percentage deviation of an economy from its sustainable growth path. We identify the major turning points in the U.S. output gap cycle using the quarterly estimates from the OECD. Since our back-test uses monthly data, we use the ISM manufacturing confidence survey to pinpoint exactly which of the three months of a quarter saw the change in momentum. There have been four clear up-cycles since 1970 and the March 2003 low appears to have marked the start of a fifth (Chart 4). Chart 4: U.S. Output Gap Estimate showing Major Peaks and Troughs 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Jul-69 Jul-71 Jul-73 Jul-75 Jul-77 Jul-79 Jul-81 Jul-83 Jul-85 Jul-87 Jul-89 Jul-91 Jul-93 Jul-95 Jul-97 Jul-99 Jul-01 Jul-03 -10 -8 -6 -4 -2 0 2 4 6 Source: OECD. Shaded areas denote up-cycles in the output gap. We have absorbed “mini-cycles” like the double-dip recession of 1981/2 into these longer-term trends. Some significant international events like the Asia Crisis or Russia’s 1998 devaluation don’t show up. The U.S. economy shrugged them off. � Peaks and Troughs in the Inflation Cycle We use a similar approach to identify turning points in the U.S. inflation cycle. We focus on the year-on-year rate of headline consumer price inflation as this is the measure targeted, to varying degrees, by the Fed and other central banks – and the Investment Clock model is designed to anticipate their policy changes. The two oil shocks of the 1970s are very clear (Chart 5), as is the overheat in the late 1980s. However, the inflation rate simply tracked sideways in the mid-1990s and the cycles have been muted in recent years. This reflects the fact that core inflation has been fairly stable, but the oil price has not. There have been four clear up- cycles in the U.S. output gap since 1970 and March 2003 appears to have marked the start of a fifth The Investment Clock – 10 November 2004 8 Refer to important disclosures on page 28. Chart 5: U.S. Annual Rate of Headline CPI showing Major Peaks and Troughs 0 . 1 0 . 2 0 . 3 0 . 4 0 . 5 0 . 6 0 . 7 0 . 8 0 . 9 Jul-69 Jul-71 Jul-73 Jul-75 Jul-77 Jul-79 Jul-81 Jul-83 Jul-85 Jul-87 Jul-89 Jul-91 Jul-93 Jul-95 Jul-97 Jul-99 Jul-01 Jul-03 0 2 4 6 8 10 12 14 16 Source: U.S. Bureau of Labor Statistics. Shaded areas denote up-cycles in inflation. � Defining the Four Clock Phases Having defined the growth and inflation cycles, we allocate each calendar month to a particular phase of the Investment Clock as the model dictates. For example, the first phase in our back-test period is April 1973 to December 1974. The output gap was falling but inflation was rising, making this “Stagflation”. The Clock most often moves forwards in the correct sequence (Chart 6). The back-steps in the mid 1980s and mid 1990s are both associated with external disinflation shocks, the first a collapse in the oil price when OPEC agreements broke down, the second the Asia Crisis. In retrospect, these events were great for the U.S., keeping inflation in check without the need for a domestic economic downturn. The apparently out-of-sequence Stagflation phase in late 2002, early 2003 reflects an external inflation shock, the run up in oil prices before the Iraq War. Characteristics of the Back-test Period We are looking at a fairly balanced period overall. The 375 months between April 1973 and July 2004 split reasonably evenly between the four phases (Table 3). Inflation is rising half the time and falling half the time. Periods of sub-par growth are more short-lived than upturns, a consequence of the short, sharp recessions that mark the end of a typical expansion. Each historic phase lasts an average twenty months, making for a roughly six year economic cycle. Table 3: U.S. Economic Cycle Frequency and Duration Phase Total (months) Total (years) Frequency (%) Average Duration (months) I “Reflation” 58 4.8 15% 19.0 II “Recovery” 131 10.9 35% 21.8 III “Overheat” 100 8.3 27% 20.0 IV “Stagflation” 86 7.2 23% 17.2 375 31.3 100% 19.5 Note: We start our back-test in April 1973, the peak of the first output gap cycle in our data set. We end in July 2004. � The Next Stage The next stage is to group together all the months in a given phase to calculate the average returns from various assets and sectors. The oil shocks of the 1970s are very clear, as is the late 1980s overheat Having defined the growth and inflation cycles, we allocate each calendar month to a particular phase of the Investment Clock as the model dictates Each of the four phases has lasted an average twenty months, making a roughly six year economic cycle The In v estm ent Clo ck – 10 N o v em b er 2004 Refer to im portant disclosures on page 28. 9 Chart 6: The Four Phases of the U.S. Investment Clock since 1970 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Jul-69 Jul-71 Jul-73 Jul-75 Jul-77 Jul-79 Jul-81 Jul-83 Jul-85 Jul-87 Jul-89 Jul-91 Jul-93 Jul-95 Jul-97 Jul