Article: Friday, 18 October 2024
This blogpost from Dr Thomas Lambert, associate professor of finance at RSM, discusses what tight polling in the run-up to the US presidential election on 5 November means for stock prices.
The outcome of the US presidential election is still highly uncertain, and with it the future direction of the country’s economic policy. In this blogpost, I explore why stock markets may react strongly to the election that’s still too close to call (at least at the time of writing). I draw insights from the surprise result in 2016, which triggered rapid market adjustments when investors reassessed their policy expectations under a Trump administration.
Stock prices reflect today’s value of companies’ expected future cash flows (or profits, this is inaccurate but I’m simplifying). Investors buy shares in anticipation of future cash flows, so policy changes can significantly impact these expectations. For instance, if investors expect cash flows to decrease due to a higher corporate tax rate, stock prices will typically fall, and vice versa. Therefore, events that alter these expectations – such as elections – can lead to noteworthy stock price movements because they often imply potential shifts in policy.
The change in the market price of any stock after an election outcome should reflect both the difference in its expected payoff under each possible outcome and the pre-election probability that the outcome occurs. The 2016 US presidential election stands out as a notable case study. Prior to that election, markets largely priced in a Clinton victory; her odds exceeded 75 per cent on election day according to betting markets. The stark contrast between Clinton’s and Trump’s proposed economic policies explains the strong reaction in stock prices when Trump unexpectedly won. In essence, the market’s reaction on election day wasn’t just about who won – it was about the size of the surprise. Had Trump’s victory been anticipated, there would have been little reaction in the markets because his policies would have already been factored into stock prices.
The stock market overall saw gains the day after Trump’s surprise victory. However, this overall effect masked considerable variation across stocks: stocks expected to benefit from Trump’s policies experienced large gains, while those expected to benefit from Clinton’s policies experienced declines. Research has documented the factors that led to these relative winners and losers.
Among Trump’s key policy proposals were a reduction in the corporate tax rate from its level of 35 per cent, the expensing of capital expenditures with limits on interest deductions, and the taxation of accumulated foreign earnings. Although Trump’s proposals did not include a border adjustment tax, he promoted increases in tariffs during his campaign and hinted at other measures to protect American businesses.
A study published in the Journal of Financial Economics found that expectations of corporate tax cuts significantly influenced stock returns. Firms with high effective tax rates gained, while those with deferred tax assets lost value. Differed tax assets are like a ‘tax credit’ that companies can apply to future profits. Therefore, companies with these tax credits ended up losing value because expectations of corporate tax cuts made those credits less valuable. Moreover, concerns over retaliatory tariffs and unfavorable tax treatment for foreign earnings negatively impacted internationally oriented firms.
Interestingly, the speed at which the market responded varied depending on the tax factors in question. Easily assessed consequences – such as tax rates or deferred tax assets – were priced faster than more complex issues – such as foreign exposure. This reveals a gradual incorporation of expectations about tax and trade policies into market prices, particularly in the days immediately following the election.
Another study estimated the value of political connections by examining firms that had business relationships with Trump prior to his election campaign. When these firms suddenly found themselves with a friend in the
White House, they saw a 3.7 per cent abnormal return over the following 21 days. Interestingly, in the post-election period, firms with presidential connections benefitted from better performance, more government contracts, and favourable regulations compared to non-connected firms.
While these benefits enjoyed by firms within Trump’s network could be interpreted as signs of cronyism or even corruption, they could also suggest Trump’s industry background helped bridge information gaps between policymakers and the private sector. The study finds both interpretations as observationally equivalent and thus refrains from making strong claims of cronyism.
Uncertainty remains high as we approach the election on November 5, 2024. The current race is a toss-up (see predictions on sites like www.pollyvote.com), with sharp price movements likely to occur post-election. However, the likelihood of a Trump victory now appears greater than it was in 2016, meaning the ‘size of the surprise’ is smaller.
Differences in policy between Harris and Trump, particularly on corporate taxation and trade, will shape investor expectations, as they did in 2016. Trump’s proposal to lower the corporate tax rate to 15 per cent could benefit more high-tax firms, while Harris’s plan to raise the rate to 28 per cent might impact more negatively firms with substantial tax burdens. Additionally, Trump’s focus on tariffs could result in significant losses for US firms with extensive foreign exposure, as renewed international trade tensions may have asymmetric effects on US companies and those from trading blocs like the EU and China.
Beyond taxes and trade, other policy differences are expected to play a larger role in investor decision-making this time. Key areas of divergences include technology regulation, which could affect data privacy laws and antitrust enforcement, energy policies, which may shift focus between fossil fuels and renewable energy, and climate change policies, which could increase costs for carbon-intensive sectors or stimulate growth in green technologies. More generally, firms ideologically aligned with the winning party could see greater returns around the election day.
As the 2024 election approaches, stock market volatility is likely to persist, driven by changing political developments and how investors perceive the future economic landscape under the next president. Let’s see how stock markets react in the aftermath of 5 November.
Science Communication and Media Officer
Corporate Communications & PR Manager
Rotterdam School of Management, Erasmus University (RSM) is one of Europe’s top-ranked business schools. RSM provides ground-breaking research and education furthering excellence in all aspects of management and is based in the international port city of Rotterdam – a vital nexus of business, logistics and trade. RSM’s primary focus is on developing business leaders with international careers who can become a force for positive change by carrying their innovative mindset into a sustainable future. Our first-class range of bachelor, master, MBA, PhD and executive programmes encourage them to become to become critical, creative, caring and collaborative thinkers and doers.
