Equity markets continue to trade near all-time highs as investors digest the implications of the recent election results. With Republicans taking both the Presidency and Congress, markets are anticipating a pro-growth agenda facilitated by tax cuts and deregulation. While the market’s initial bounce illustrates this optimism, performance has been more mixed since then as many important details of the agenda remain unknown. Most prominent is the degree to which this agenda is financed by further deficit spending, which markets fear could drive further inflation and growth in the national debt. Alternatively, budget cuts and tariffs might be sufficient to offset the loss of tax revenue. As they say, “the proof is in the pudding”, and markets are currently waiting to see the details before leaning further into this rally.
A deeper look at the market movement in the last week speaks to this combination of uncertainty and cautious optimism. For one, much of the initial rally was simply the reduction in risk premium that had been built into prices based on fears of a contested election. When that didn’t happen, the collective sigh of relief caused the stock market to immediately reprice upwards. However, movement since then has been much more nuanced and driven by expectation of sector effects.
For example, cyclical sectors like Banks, Energy, and Small Caps have outperformed due to the expectation of benefitting from higher growth and deregulation, whereas sectors that rely heavily on imports, such as Consumer Discretionary and Industrials, have lost their momentum. Likewise, domestically oriented stocks are trading better than Multinational companies that would be negatively impacted by trade frictions and a strong dollar. We’ve also seen some more recent movement based on Administration cabinet picks, with Tesla stock benefitting from expectations that Elon Musk can secure desired regulatory changes in the EV market, while biopharma companies have sold off on RFK Jr’s nomination for Health secretary. So, while movement collectively speaks to a sense of cautious optimism, performance under the surface illustrates that much uncertainty remains.
Another area where we’re seeing this mixed messaging is in comparing fundamental strength as reflected in corporate earnings with the yield curve and changing expectations for monetary policy. By most accounts, the earnings backdrop has continued to be strong, with three-quarters of companies in the S&P 500 beating earnings estimates in the 3rd quarter and 62% beating on the top-line. An extension of the cut in corporate tax rates would be a further boon to their bottom line, helping to counter the currently elevated multiple expressed in the market.
Nevertheless, the interest rate picture has shifted notably since the election. Long term yields have been rising amid concerns of new inflation/debt headwinds, while short-term yields have been pressured by falling expectations for further interest rate cuts by the Fed. Both are related to the fact that inflation, while largely back down to target, is still slightly elevated and at risk of rising again if the economy undergoes a new reflation cycle. While sectors like banks would benefit from a steeper yield curve, higher rates will be a headwind for sectors like Real Estate, Utilities, and Consumer Discretionary. Higher rates also simply make Treasuries more attractive relative to stocks, which in turn puts more pressure on stocks to growth into their multiples, largely through continued strength in the Technology sector, which has dominated performance for much of the last year.
Collectively, the large rally year to date speaks to investors’ collective belief that strength in the economy and tailwinds to corporate earnings are net beating out these other various risk factors. Despite the market’s elevated valuation, the increase in market breadth over the last few months has made the market less susceptible to an unwind in the AI trade, for example, than it was just a few months ago. A wider variety of sectors now stand to benefit from an emerging pro-growth and deregulation-oriented agenda, which takes some pressure off the market’s biggest leaders.
Overall, we remain cautiously optimistic on markets based on these fundamental strengths, but believe markets will remain prone to volatility as more details arrive regarding the policy and budgetary agenda for the new year. Geopolitics also remains in the background as well despite having limited effect so far this year. Collectively, these factors reinforce the importance of maintaining a steady and structured approach to capital deployment. We are continuing to monitor these developments closely and are making tactical shifts in portfolios as we see opportunities to reduce risk or realign exposures as we head into 2025.