Stock market volatility is always around the corner

The Citigroup Economic Surprise Index, which tracks how economic data are faring relative to expectations, has been surprising strongly to the upside in recent months in nearly all economies, indicating that economic data are coming in well ahead of expectations.

Notably, GDP showed surprisingly solid growth in all the major economies in the final quarter of 2016.

Meantime, the Global Composite Output PMI rose to a 22-month high of 53.9 in January. The PMI for manufacturing hit its highest level in two-and-a-half years.

In the eurozone, the Composite PMI is at its best level in more than five years. Other leading activity indicators in major economies have also picked up strength in recent months.

Sentiment is also being boosted by hopes that the Trump administration will deliver a boost to the US economy through a promised expansion of fiscal policy, via cuts to corporate and income taxes and increased infrastructure spending, as well as through a programme of deregulation.

Markets are also being underpinned by expectations that apart from in the US, monetary policy is set to remain very loose for the foreseeable future.

Both the European Central Bank and Bank of Japan are expected to maintain interest rates at negative levels for a considerable period after that.

Futures markets do not see inter-bank rates turning positive in the eurozone until the end of 2019. They are then expected to rise to just 0.5% by the end of 2021.

Even in the US, despite a somewhat hawkish tone to Federal Reserve Chair, Janet Yellen’s testimony to Congress last week, markets remain doubtful that rates will rise to the extent projected by the Fed.

Ms. Yellen has warned that it would be “unwise” to wait too long before raising rates again following the hike in December.

The latest Fed interest rate projections show that it expects to raise rates by 75 basis points in each of the next three years, bringing the Fed funds rate up to almost 3% by the end of 2019.

Markets are more circumspect, looking for two rather than three 25bps rate hikes per annum over the next two years and then just one rate increase in 2019, which would leave rates a full 1% lower than projected by the Fed by end-2019.

This is not that surprising given that the Fed did not follow through on projected rate hikes over the past couple of years and instead has acted very cautiously in regard to policy tightening.

However, if President Trump does start to implement his fiscal programme, then significant Fed rate tightening would seem very likely.

Nonetheless, there seems a good deal of optimism in markets that while the global economy is entering a period of stronger growth, interest rates will remain very low as underlying inflation is expected to stay very subdued.

The risk for markets is that this supportive backdrop starts to give way. Growth could slow again as the recent rise in headline inflation dampens consumer spending.

Or benign interest rate expectations could be also disappointed, with the US most at risk in this regard.

Geopolitical risk factors also need watching, in particular upcoming elections in Europe. Volatility in markets does not remain very low forever.