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What Are Financial Markets Saying About the Election?

What Are Financial Markets Saying About the Election?

December 02, 2016 |0 Comments

by Scott E. Hein, E.W. Williams Jr. Centennial Bank Chair in Finance, Rawls College of Business, Texas Tech University


Since the Presidential and Congressional elections three weeks ago, we have seen significant financial market reaction here and abroad. Now might be a good time to consider these events as it seems that things have settled down in the last few days. The fact that financial markets have reacted sharply is consistent with the obvious point that the election results were not well anticipated. If this event had been well anticipated we should have seen little to no market reaction. The sharp market changes signals that market participants are adjusting their thinking to events they didn’t fully anticipate.


Broadly speaking, since the election we have seen U.S. stock prices increase, the value of the dollar strengthen against major currencies, and the value of “risk-free” Treasury bonds fall. All of this is consistent with market participants becoming more optimistic about the U.S. economy. To a great extent such optimism is generally associated with anticipated tax reductions, deregulation or more broadly regulatory reform and the potential for fiscal stimulus. 
It appears that investors, at the margin, are seeing enhanced opportunities associated with being “residual claimants in a capitalist setting”, as opposed to preferring the perceived safety of U.S. Treasury securities. This relative investing pattern is the reverse of the “flight to quality” that was observed in response to the financial crisis. 


Such broad moves suggests that the economic platform of President-elect Trump and a Republican controlled Congress are perceived as being more beneficial to the U.S. economy than the Obama-Clinton economic agenda, and/or investors are anticipating keeping more of their investment gains than would have been otherwise. The latter development is consistent with the planned tax reductions and reforms especially as they relate to business incomes.


The broad strengthening of the U.S. dollar further appears to suggest that any protectionist efforts on the part of the new administration will be minor themselves, or will not have depilating effects on the relative U.S. economic performance. The strengthening of the U.S. dollar does not appear to foretell an isolationist U.S. economy in the future.


In addition to these big takeaways, there are a couple of more subtle, behind the scenes changes in financial markets that deserve attention. The first is that not all interest rates have increased proportionately. Indeed longer-term interest rates have risen more than short term interest rates. This suggests that investors are looking beyond the December meeting of the Federal Open Market Committee, and are seeing greater economic strength longer term. To the extent the shape of the yield curve is a forecaster of recessions, the steepening shape of the yield curve suggests a recession is less likely.


The second subtle development is that not all stock prices have risen proportionally. Indeed stock prices associated with smaller and mid-sized firms have significantly outpaced their larger capitalized brethren. This suggests that equity market participants either see the economic improvement favorably impacting smaller firms relatively more, or that such firms will benefit more from anticipated tax reform. Financial stock prices, especially for smaller financial entities, such as banks, have also risen more rapidly than the stock market as a whole, suggesting that the financial sector of the economy will be favorably impacted by either regulatory reforms, broad macro-economic strength, or will receive new beneficial tax treatment.


In summary, financial markets have rapidly adjusted to a new world that was little anticipated. Broadly the financial market reaction suggests an optimism for the future. Still, it is appropriate to remember, however, than markets are not clairvoyant, and therefore what appears to be expected now doesn’t have to happen.