Despite diminished expectations for growth and inflation, stocks enjoyed a stellar first half. While the latter half of 2016 was characterized by reflation, higher interest rates and a stronger U.S. dollar, the first half of 2017 witnessed decelerating inflation, modestly lower long-term rates and a collapse in the dollar. Nonetheless, investors merely shrugged and rotated into different parts of the market, notably healthcare and technology.
Along with the shift in sector and theme came a shift in style. Momentum came roaring back, after trailing value in the second half of 2016. Based on the USA MSCI Momentum and Value indexes, momentum thrashed value during the first six months of the year, 18% to barely 6%. However, in recent weeks momentum has been stalling, raising the question of whether it can continue to lead the market. Although my colleague Richard Turnill still likes momentum, I’m a bit more of a skeptic. Here are two reasons why:
1. Momentum had a perfect environment in the first half of 2017.
Historically, momentum performs best in an environment of low and stable volatility—exactly the regime that has dominated this year. Although talk of reflation faded, low interest rates, a soft dollar and historically tight spreads kept financial conditions absurdly easy. In June, the Global Financial Stress Index hit its lowest level since late 2014. A lack of stress and easy money tend to support momentum investing. In this environment it is best to follow Newton’s First Law of Motion: An object in motion stays in motion.
2. This happy state of affairs will be difficult to maintain.
In order to maintain these idyllic conditions, the global economy will need to remain in a goldilocks state. In other words, an economy strong enough to prevent recession fears but not so strong as to incite central banks into doing the unthinkable: tightening monetary conditions. But this is unlikely. Central banks in Europe, China, the United Kingdom as well as the Federal Reserve are looking to, at the very least, withdraw accommodation. Tighter monetary and financial conditions suggest higher volatility, which in turn is likely to hamper the momentum trade.
One indicator to watch is bond market volatility, which will provide an early warning to changing financial market conditions. After hitting a four-year low in late June, bond market volatility—measured by the MOVE Index—has risen by over 10% (see the chart below). Historically, returns to momentum have been inversely related to changes in the MOVE Index. Every 1% move higher in bond market volatility has been associated with a 0.07% decline in momentum.
History may be repeating itself as we’re starting to see the first, albeit small, cracks in the momentum trade. While still posting stellar year-to-date returns, momentum was down around 1% in June, underperforming both quality and value. Should financial conditions continue to shift, volatility is unlikely to remain as quiescent. In a less calm world, investors will want to embrace more balance in their style exposure, with quality the most likely factor to take the baton and lead.