A throwaway comment at the end of my previous post may have been misunderstood. So today I’ll provide a more complete interpretation of the market response to the recent election.
There were a number of significant market responses to the election, including:
1. Significantly higher stock prices2. A stronger dollar3. Higher interest rates4. Higher inflation expectations in the TIPS market
I made a sarcastic remark about how the press treated this as a positive reaction to the election. I actually think it is a somewhat positive reaction, but it’s hard to square that view with the media’s pre-election commentary on the state of the economy.
Over the past year, there have been many press reports indicating that the public had a very negative view of the state of the economy. If someone responded “But stocks are hitting record highs”, they were shouted down. The general view was that the public doesn’t care about a booming jobs market, or rapid GDP growth, or record stock prices. For the average person, the only thing that matters is the high inflation of 2021-23. (To be clear, this is not how I view the economy.)
And perhaps that’s true! Maybe that is the only thing that the public cares about, at least at the current moment in time. 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 markets responded as they did. The sharp rise in stock prices is almost certainly at least partly linked to expectations of lower taxes on corporate income, at least relative to the Democratic alternative. In that case, the response was probably not just due to Trump’s election, but also to the GOP taking the House and Senate. Prior to the election, the House was viewed as being something of a toss-up.
It is also possible that stocks 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 expulsion of illegals) would produce slower growth. This is a sort of mirror image of the Biden period, where GDP growth was strong due to high rates of immigration, despite a move toward more regulation of business.
In my view, the higher inflation expectations reflect the expected impact of tariffs. In principle, the Fed could offset the effect of tariffs, but because of their “dual mandate” they would likely allow at least some of the tariffs to pass through in higher prices.
The stronger dollar also reflects expectations of higher tariffs. Tariffs do not reduce the trade deficit (which is caused by a savings/investment imbalance), because the dollar appreciates enough to offset the gain to domestic producers from higher trade barriers.
Higher interest rates likely reflect expectations of bigger budget deficits. Both candidates proposed policies that would have worsened the deficit, but Trump’s proposals were even more extreme, largely due to his support for much lower corporate and personal income taxes, at least compared to the Democratic alternative.
Stocks have continued to rise even after the election results were known. (BTW, I believe the markets almost immediately understood that the GOP had taken the House, even though the media would not call this until more votes were in.) I suspect the delayed market reaction partly reflects subsequent statements by Trump insiders that some of his more radical proposals such as higher tariffs might be dialed back, or used as a negotiating tool.
Market reactions are always provisional. They reflect the change in market valuation based on investors’ best guess as to the value of companies before and after a piece of news comes in. But nothing is ever final. News will continue to come in as the new administration’s plans become clearer, and markets will continue to evaluate that news and reprice assets on the basis of the new information.
PS. I was a bit disappointed to see the stock prices of Fannie Mae and Freddie Mac rise very sharply on the election news. I’ve long been in favor of abolishing those examples of crony capitalism, but it seems they are actually likely to be further helped by the government. I worry that our financial system’s moral hazard problem will get even worse.
