NewsMarkets rally on Trump victory amid investor paradox

Markets rally on Trump victory amid investor paradox

Financial markets' reaction to the US election results, specifically Republican candidate Donald Trump's victory, suggests that investors view this as a positive scenario. How can this be, given that many economists believe Trump's return to the White House will harm the world's largest economy?

On Wall Street, Trump's victory delighted not only his supporters.
On Wall Street, Trump's victory delighted not only his supporters.
Images source: © Getty Images | Bloomberg

9:03 AM EST, November 7, 2024

Optimism on Wall Street, accompanied by the dollar strengthening observed on Wednesday, was also noted during the election campaign whenever momentum shifted in favor of the former US president. This phenomenon has been labeled "Trump trades," where investors take market positions that could yield profits in the event of a Republican candidate's victory.

Increases in American stock prices and the strengthening of the dollar do not necessarily indicate that investors favor Trump. Stock exchanges, like other financial markets, resemble the previously popular "beauty contest" in the British press. In this contest, participants needed to select the most attractive faces from 100 photographs based not on their own preferences but on the predicted preferences of others. The winner was the one who most accurately identified the photos chosen by the majority. Therefore, one had to anticipate which photographs would appeal to people who were also guessing.

This metaphor, introduced by John Maynard Keynes, a prominent 20th-century economist, remains relevant today. Investors bet on assets they believe others will choose. If someone expects others to bet on rising stock prices following Trump's victory, they will likely make the same move. Consequently, if Trump indeed returns to the White House, investors might start realizing profits, and the "Trump trades" might leave no lasting impact.

Why investors believe Trump will grow their portfolios

But why does the market's "beauty contest" show such results? Could the financial world be experiencing some form of Stockholm syndrome? Probably not. There is simply a compelling (although not necessarily accurate) narrative suggesting that Trump's administration will benefit investors' portfolios. This narrative allows market participants to predict what positions others will take based on the election outcomes.

A June CNBC survey highlighted the existence of this narrative—or myth—, in which Joe Biden was still considered Trump's opponent instead of Kamala Harris. Among the 400 investors surveyed, 67% believed that Trump would be better for Wall Street's prosperity than Biden.

One source of this belief might be historical precedent. During Donald Trump's first term, from 2017 to 2021, the main American stock index, the S&P 500, rose by more (68%) than it did under Biden's administration—both up to that time and to date (51%). However, when considering the periods from election to election, Trump's advantage disappears. From November 2016, when he took office, to November 2020, when Biden won, the American stock market barometer jumped by 62%. Yet by the next election day, it had risen by 65%. This approach makes sense because the stock market's condition from the presidential election to the winner's inauguration can already be attributed to them.

The narrative that Donald Trump's administration will favor Wall Street can also be justified by his program. The 47th US president is proposing tax cuts for companies, particularly domestic manufacturers, and economic deregulation, including in the mining and energy sectors. These promises are considered credible because he managed to reduce corporate tax burdens during his first term despite working with a divided Congress on fiscal matters. It may now be even easier if both congressional chambers are controlled by Republicans, which is likely. Meanwhile, Kamala Harris has proposed tax increases for companies.

A strong dollar attracts capital, which strengthens the dollar

The market appears to believe that under Trump's administration, company profits will grow faster than they would under Harris. Additionally, there is a strong belief that his economic policy will lead to the appreciation (increase in value) of the dollar. From the perspective of foreign investors, this increases the returns from American assets. The prospect of a stronger dollar attracts capital to the USA, also supporting stock price increases. This creates a self-perpetuating mechanism.

However, the dollar's appreciation in response to Donald Trump's victory—the second president in US history to serve two non-consecutive terms—does not clearly indicate that his administration excites investors. It could harm the American economy and company performance if it becomes entrenched.

Firstly, the American dollar is considered a safe haven in financial markets during times of turmoil. Expectations for its appreciation partly stem from the belief that Trump's stance towards Russia increases geopolitical risk. Similar effects would result from his announced radical tariffs on imported goods from China and allied countries.

Secondly, tax cuts will likely worsen the US public finances. According to estimates described on money.pl a few days ago (link to the article below), implementing all of Trump's promises would lead to the US public debt rising to 160% of GDP by 2035 from about 100%. In almost any other country, such a prospect would weaken capital flight and weaken currency. However, due to the dollar's role, the USA may not face this threat in the coming years. Yes, treasury bond prices will fall slightly, but this—and the subsequent higher interest rates, which I'll discuss shortly—will increase their yields, boosting their attractiveness to foreign investors.

Trade war? Unpredictable effects

Thirdly, such trade policy, if it reduces the US trade deficit, will also directly support the dollar's rise. However, as economists widely expect, it will also lead to higher inflation and, consequently, higher Fed interest rates than in an alternative scenario where Kamala Harris would win the elections.

Limiting immigrant inflow into the USA, a key point of Trump's program could also fuel inflation. Simultaneously, higher tariffs across the Atlantic will harm the economies of American trade partners, resulting in a more accommodative monetary policy there. A greater interest rate differential between the USA and other large economies will favor dollar appreciation.

The problem is that a global trade war threatened by Trump's policy will likely have long-term negative consequences for the American economy. Higher inflation and interest rates will restrict American consumer spending. And dollar appreciation will negatively affect the competitiveness of American enterprises.

Trump has acknowledged this himself, as he has repeatedly suggested he would prefer a weaker currency, blaming high exchange rates on currency manipulations by trade partners.

Will the new president be able to weaken the dollar? Perhaps, if, for instance, the threat of tariff hikes compels other countries to take coordinated actions to reduce the American currency's exchange rate—similar to the mid-1980s Plaza Accord. However, this scenario seems unlikely. If it materializes and the dollar enters a prolonged downward trend, the attractiveness of American assets would decline. This would similarly occur if Trump's administration disrupts the US economic cycle, prompting the Fed to ease monetary policy.

Ultimately, we face a paradox: American companies' stocks and the dollar are rising for reasons that could, in the long term, prove detrimental to the US economy, with dollar appreciation becoming a burden. Due to the dollar's unique global role, this situation might persist for some time, especially since investors favor myths and simple narratives like Trump's supposed market favorability. However, the reality of an unpredictable Republican presidency will be far from simple. Thus, the outcome of the market's "beauty contest" will likely shift multiple times throughout his presidency.

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