Different asset classes and business sectors tend to perform better than others at different phases of the economic cycle. The Investment Clock shows which asset classes and stock sectors have historically outperformed in each phase of the economic cycle according to our research. The model was created by Fidelity to guide asset allocation in funds, and is not intended as a tool to predict which asset classes or stock sectors are likely to outperform in any given economic phase.
The Investment Clock separates the economic cycle into four phases based on the strength of economic growth and inflation. In the Reflation phase, economic growth is weak, while declining commodity prices and spare capacity causes inflation to fall. In the Recovery phase, economic growth begins to pick up as efforts by governments to stimulate the economy take effect, but inflation continues to fall. In the Overheat phase, economic growth is strong and inflation climbs as companies run out of capacity, prompting governments to introduce measures to cool the economy. And lastly, in the Stagflation phase, GDP growth falls but inflation continues to rise as workers demand pay rises above the cost of living and companies raise prices to protect margins.
As the economy moves through its cycle, Fidelity uses the Investment Clock to rebalance asset allocation in favor of the asset class most likely to outperform based on historical research. Typically, bonds outperform during the Reflation phase when governments tend to lower interest rates to stimulate economic growth, stocks outperform during the Recovery phase and commodities during the Overheat phase as investors become risk seeking, and finally cash tends to be the best performer during the Stagflation phase when weak economic growth or recession tends to cause prices of other assets to fall.
In addition, the economic cycle also influences how different sectors of the stock market perform. In the Reflation phase, for example, the top three performing sectors are historically consumer staples, financials and consumer discretionary stocks. In the Recovery phase, consumer discretionary, telecom and technology stocks take over leadership. In the Recovery phase, technology, industrial and energy stocks perform best. And lastly, energy, pharmaceutical and utility stocks outperform during the Stagflation phase.
For ordinary investors following a long-term investment plan, what the Investment Clock shows is the importance of creating a diversified investment portfolio. As different asset classes and business sectors take over leadership during the economic cycle, investors need to maintain a diversified range of investments to capture their growth potential and maximize returns.
One approach that uses the economic cycle as a basis involves investing around a core portfolio. Using this strategy, investors might invest 60-80% of their assets in a core portfolio of well-diversified, balanced funds and the remaining 20-40% of their assets in funds offering exposure to specific asset classes and stock sectors to take advantage of the outperformance of different types of investments in each phase of the economic cycle.