Volatility sits at historically low levels for most asset classes, which is at odds with the redrawing of the political and economic landscape currently underway in the U.S., UK and Europe. This complacency could last a while longer, but historical precedents suggest it is unlikely.
“Transformational” is a term often overused. But not so in 2017.
After all, President Donald Trump is attempting to implement the most aggressive deregulation agenda in a generation, as well as challenging the parameters of U.S. presidential power. In the UK, Parliament has voted to initiate the process to leave the European Union, and there is a slate of pivotal elections in the EU, with the French, Dutch and German electorates having an opportunity to cast a vote against the establishment.
Despite this upheaval, financial markets have been remarkably calm. The Chicago Board Options Exchange Volatility Index (VIX), which measures the market’s expectation of volatility over the following month, is as low as it was in 1994 and 2007, two years that preceded periods of much greater volatility. It is a similar story in both the UK and Germany, where volatility indices are also hovering near their lows. In effect, the low volatility suggests investors expect very little change in market direction.
Similar patterns can be seen in bond markets where, despite rising government bond yields, volatility seems to have fallen since the beginning of the year, particularly in Europe. In foreign exchange markets, volatility is also subdued, although it has risen above recent low points.
Don’t let go of the U.S. coat-tails
One reason why volatility has not increased despite sweeping changes to the political and economic landscape is that investors seem to be taking for granted that Trump’s stimulus plans, which include corporate tax cuts, regulatory overhaul and infrastructure spending, will be implemented and thus extend the business cycle. A stronger U.S. economy would be the catalyst for global growth to break out of the lacklustre environment of the past few years.
While the infrastructure discussion seems to have abated, market participants are focusing on the other two items of Trump’s pro-business agenda: tax cuts and deregulation. The chief U.S. economist for RBC Capital Markets says tax cuts could boost GDP by 0.4–0.6 percent in 2017 and 0.7–0.9 percent in 2018, lifting growth rates above 3 percent for both years. In turn, the chief U.S. market strategist for RBC Capital Markets estimates corporate tax cuts “could easily add 5–7 percent to profits annually going forward”. While tax reform deliberations are ongoing, a proposal to allow companies to write off plant and equipment costs in the year of purchase could encourage further capital investment, a clear potential boon to the U.S. economy.
Deregulation is also expected to unleash growth, with banks and the energy sector benefiting most. The new administration is expected to revisit the capital requirements for U.S. banks with a view to lowering them and likely roll back some elements of the Dodd-Frank Act. Bankers argue both steps would enhance their ability to lend to the real economy. Whether it is desirable to lower capitalisation requirements remains up for debate, though prudent and sensible deregulation and simplification could indeed be beneficial to lending activity.
As for energy, the new administration could prove to be the most fossil fuel-friendly administration in the modern era, even more so than the administration of George W. Bush who, along with his vice-president, Dick Cheney, came from an oil background. Indeed, pipeline opportunities have already opened up.
The pharmaceuticals sector could also benefit from a lighter regulatory touch. Drug pricing and the potential repeal of Obamacare are the two main headwinds, but the potential acceleration of the currently slow and torturous approval process for drugs could help offset them. Figures from the U.S. Food and Drug Administration show that the cost of developing a drug has increased by 14 times since the 1970s to $2.6 billion per drug. Some of the increase can be explained by the complexity of new drug treatments, but increasingly stringent regulations have had a significant role in rising development costs.
Overall, policies that benefit U.S. business sentiment and the economic cycle are, by extension, helping to prop up growth elsewhere.
Europe in particular has benefited from the stronger dollar helping its export sector. With buoyant manufacturing, the region is experiencing the strongest economic momentum in several quarters. Economic sentiment is at a six-year high, and unemployment has fallen back to single-digit levels. This gathering momentum has helped contain volatility in Europe.
Derailing the low volatility environment
Given that the trajectory of the U.S. economy is central to the low volatility environment, several factors could derail this rosy scenario. If Trump’s pro-growth proposals are watered down or their implementation is delayed, it would be an unwelcome development and likely cause market jitters.
The most likely scenario to derail U.S. growth prospects and stoke volatility would be if the U.S. Federal Reserve, concerned by an increase in wage-push inflation, increases the magnitude and pace of expected interest rate hikes, choking off the recovery.
Alternatively, a crisis in Europe brought about by an anti-EU government in France could boost volatility. Markets worry that if National Front leader Marine Le Pen wins the French presidency, she will push through her anti-EU agenda and call a referendum on membership. The path of France exiting the EU is far from straightforward, but after the experience of the UK, investors would understandably be jittery. With France not only being the second-largest economy in the eurozone, but also one of its founding members, the EU could hardly continue in its present form without it.
Finally, we could also see a derailment caused by a hard landing in China or the escalation of trade disagreements and tensions between the U.S. and its global trading partners, should the Trump administration unilaterally impose tariffs. Such actions typically provoke threats of retaliation, and trade wars tend to be detrimental to economies and thus to financial assets. The eurozone, with its current account surplus of more than 3 percent of GDP, could find itself in the crosshairs given the Trump administration’s recent rhetoric.