CIO Update: Market Reaction to Election Results

The results of arguably the most closely watched election across the world are finally in, and the U.S. stock market has reacted positively to Donald Trump’s win and the shift of Senate control to a Republican majority. We are still awaiting the results of the House of Representatives, but expectations are for Republican control in that chamber as well.

Markets dislike uncertainty, so a decisive victory has proven favorable for the stock market. Polls had shown a statistical dead heat between the candidates, leading many to expect days of uncertainty before learning the results. Exit polls indicated that the key decision point for many voters was the economy, and on that front, Trump’s proposed policies—extending tax cuts, reducing regulations, and imposing tariffs—appear to have resonated with them.

U.S. stocks overall were up about 2.5% in the post-election day rally, with small cap stocks showing the biggest jump of nearly 6%¹. The rise in U.S. stocks reflected the sentiment that Trump’s policies are favorable for business. Among the pro-business policy proposals are a potential lowering of the corporate tax rate from 21% to 15% as well as a push for deregulation by the incoming administration, which is expected to be beneficial specifically for companies in heavily regulated sectors such as financials and energy.

Small cap stocks by far registered the largest gain in the aftermath of the election result and this has been attributed to a few different factors:

• Investors’ appetite for risk is higher now given the expectations of a more favorable business environment under the new administration, and this benefits small company stocks, which have lagged the strong performance of large cap stocks so far this year.
• The Tax Cut and Jobs Act (TCJA), which was set to expire in 2025, includes some small business tax provisions like the 199A deduction that allows small businesses to exempt 20% of their income from tax, effectively lowering their marginal rate. Approximately, 26 million US small businesses claim that deduction². A Republican win means that the TCJA is likely to be extended.
• Tariffs and protectionist policies are expected to benefit small companies more than large companies given that smaller companies are likely to have fewer international operations.

Bonds, in contrast, have not been reacting as positively and appear to be pricing in much of the negative impact associated with proposed Trump policies, namely increased budget deficits because of lower taxes. The ten-year treasury yield rose on Wednesday to 4.44% (remember bond yields move inversely to bond prices). Although part of the shortfall in tax revenue could be offset by a proposed 10% tariff on all goods imported from foreign countries (except for China, for which a 60% tariff has been proposed), this type of revenue isn’t a panacea. The concern is that the costs of tariffs will be passed on to consumers in the form of higher prices, leading to inflation.

Why is this bad for bonds? The fear being reflected in bond markets is that, to finance higher deficits, the US government will need to continue to issue debt at higher rates, against the backdrop of an inflationary environment, to continue to attract investors.

Also, of note related to the bond market, the Federal Reserve continued on its path of lowering the federal funds rate this week and cut rates by a further quarter of a percentage point. The impact of Federal reserve action is mostly on the shorter end of the curve, whereas longer-term yields are more dependent on supply demand dynamics.

Many pundits advocated for de-risking portfolios ahead of the election to a more cautionary stance and while that may have helped mitigate some volatility in the days leading up to the election – those types of investors also missed out on the immediate pop experienced the day after the election. The S&P 500 posted its highest one-day post-election gain this year compared to all prior election years³. By maintaining disciplined exposure to stocks despite the uncertainty, your portfolio benefited.

The incoming administration’s pro-business policies may mean we have a longer runway for continued economic growth and a bull market, making the case for stocks and less loved parts of the market like small cap stocks. Though it can be tempting to extrapolate that the market reactions we have experienced in the immediate aftermath of the election will continue, we must also recognize that these are short-term reactions. The true impact on companies and the market will depend on how much of the campaign rhetoric actually makes it into policy and the details of what is implemented.