In today’s economy, it can be difficult to know what investments are most favored or held back by economic conditions. One effective solution is to classify investment vehicles according to how they perform when the economy is changing in a particular way.
The diagram above is shaped like a compass. It’s a simple scheme consisting of four basic economic scenarios that distinguish among four basic asset classes. Examples are shown in four quadrants: southwest (domestic stocks), northwest (quality domestic bonds), northeast (gold) and southeast (risky hard and foreign assets such as commodities and emerging markets). At present, with gold up from last year and spreads down, risky hard assets have already begun to out-perform other investments.
For example, safe haven investments such as government bonds and gold produce their best returns when a deceleration is under way in both economic growth and inflation. Equities (stocks) do best when inflation is decelerating but growth is accelerating. Changes in the economy’s growth and inflation rates do a very good job of explaining the investment performance of different investments. However, they do not anticipate them because the economy moves too slowly. To obtain predictive power it’s necessary to use early leading indicators or “market signals” of growth and inflation, which can be found in financial markets. The price of gold is an excellent market signal for inflation. Credit spreads between Aaa corporate bonds and lower investment grades are an excellent market signal for growth.
R. David Ranson is a senior fellow with the National Center for Policy Analysis and president and director of research at HCWE & Co.