A throwaway comment at the end of mine previous message may have been misunderstood. So today I will provide a more complete interpretation of the market’s reaction to the recent election.
There were a number of significant market reactions to the election, including:
1. Significantly higher stock prices
2. A stronger dollar
3. Higher interest rates
4. Higher inflation expectations in the TIPS market
I made a sarcastic comment about how the press saw this as a positive response to the election. I actually think it’s a somewhat positive response, but it’s difficult to square that view with the pre-election media commentary on the state of the economy.
Over the past year, there have been many press releases indicating that the public had a very negative view of the state of the economy. If someone responded, “But stocks are at record highs,” they were yelled at. The general view was that the public doesn’t care about a booming job market, rapid GDP growth or record stock prices. For the average person, the only thing that matters is the high inflation of 2021-2023. (To be clear, this is not how I see the economy.)
And maybe that’s true! Maybe that’s all the audience cares about, at least for now. But if that’s the case, then Wall Street’s reaction to the election was clearly negative, as inflation expectations rose on the news.
Now let’s think about why the markets reacted the way they did. The sharp rise in stock prices is almost certainly linked, at least in part, to expectations of lower taxes on corporate income, at least compared to the Democratic alternative. In that case, the backlash was likely due not only to Trump’s election, but also to the Republican Party capturing the House and Senate. Before the election, the House was seen as something of a toss-up.
It is also possible that stock prices rose on expectations of stronger GDP growth. Some of Trump’s policies (income tax cuts and deregulation) would produce stronger growth, while other policies (tariffs, lower immigration and deportations of illegals) would produce slower growth. This is something of a mirror image of the Biden era, where GDP growth was strong due to high immigration rates, despite a move toward more regulation of business.
In my view, higher inflation expectations reflect the expected impact of tariffs. In principle, the Fed could offset the effect of rates, but because of their “dual mandate” they would likely pass on at least some of the rates in higher prices.
The stronger dollar also reflects expectations of higher rates. Tariffs do not reduce the trade deficit (which is caused by an imbalance between savings and investment) because the dollar appreciates enough to offset the gains to domestic producers from higher trade barriers.
Higher interest rates likely reflect expectations of larger budget deficits. Both candidates proposed policies that would have worsened the budget deficit, but Trump’s proposals were even more extreme, thanks in large part to his support for much lower corporate and personal taxes, at least compared to the Democratic alternative.
Stock prices have continued to rise even after the election results were announced. (By the way, I believe the markets understood almost immediately that the Republican Party had taken the House of Representatives, even though the media wouldn’t mention it until after more votes had come in.) I suspect that the delayed market reaction was partly due to Trump’s subsequent statements -insiders reflects that some of his more radical proposals such as higher tariffs could be reversed or used as a negotiating tool.
Market reactions are always preliminary. They reflect the change in market valuation based on investors’ best guesses about the value of companies before and after news arrives. But nothing is ever final. News will continue to arrive as the new administration’s plans become clearer, and markets will continue to evaluate that news and revise asset prices based on the new information.
P.S. I was a little disappointed to see the stock prices of Fannie Mae and Freddie Mac rise very sharply after the election news. I have long been in favor of abolishing these examples of crony capitalism, but it seems that the government will help them further. I worry that our financial system’s moral hazard problem will get worse.