Thus far, 2017 has been notable for solid gains, not intellectual consistency. For various reasons, investors have demonstrated a marked preference to “barbell” their risk. Year-to-date performance suggests a preference for either very risky or very safe assets.
The year’s top performers include emerging market (EM) equities, industrial metals and the tech heavy NASDAQ, all traditional “risk-on” assets. However, defensive assets are also performing surprisingly well. See the chart below. Gold has outperformed most developed equity markets, the Japanese yen has rallied and long-dated (20+ year) Treasuries are up over 10%.
Year-to-date asset performance
Nor is this pattern limited to asset class performance. It is also evident one level down, in the performance of equity sectors and styles. High beta segments of the equity market, such as biotech and semiconductors, have posted 20% or better gains. At the same time, minimum volatility strategies have been competitive and health care and utilities, traditional defensive sectors, are the second and third best performing sectors year-to-date. What explains the paradox of risky assets and safe havens rallying together?
1. Factors in favor
This year has been about growth and momentum, both beneficiaries of the slow but stable economic regime. The unraveling of the “Trump trade” has pushed investors back into those growth names, primarily tech, that can generate organic growth. A slow but steady economy also means low economic and market volatility. This phenomenon has supported momentum. In other words, the combination of slow growth and low volatility has favored segments of the market associated with a preference for risk, when in fact what investors really want are companies that can thrive in a slow growth world.
2. Benefits of a weak U.S. dollar
Gains in the best performing asset classes can be explained by one of the weakest: the dollar. The rally in gold and emerging markets reverses the trend witnessed in late 2016, when a strong dollar led to underperformance for both asset classes. But as expectations of higher interest rates have fallen and the dollar has given back all of its recent gains, EM and gold have come roaring back.
3. Commodity supply
While industrial metals and gold are having a stellar year, the gains in some commodities do not extend to the overall asset class. Oil is the most notable laggard; robust global supply has translated into stubbornly high inventories. Similar supply issues have bedeviled other parts of the commodity complex, particularly agricultural commodities.
Going forward, apart from the idiosyncratic issues facing select commodities, the big things to watch are growth and central banks. For the current trend to continue, you need three somewhat related conditions: modest growth and inflation, low volatility and skittish central bankers. I say related because to the extent we continue to see the former, unresponsive inflation, we’re more likely to get the latter, nervous central bankers who are unwilling to withdraw accommodation. Under this scenario, the combination of “just enough” growth, macro stability and low rates may continue to make for strange bedfellows.