“Democracy is the worst form of government, except for all the others that have been tried.”
Winston Churchill
Last month handed us an end to a nail-biting finish to the 47th Presidential and 119th Congressional election. The good news is that the results were clearer than those of some of our recent elections. The bad news is that there is a lot of uncertainty over what’s next. Some have suggested they might move to Canada, whereas others are buying call options on the US stock market. What’s the smart thing to do? While teaching, researching, and debating with colleagues at Columbia University this Autumn, I have gleaned some opportunities that I would like to share. In particular, we will unpack seven takeaways and three perspectives from this election to help us best navigate these next four years.
Let us begin by recounting (pun intended) what happened. As I’ve written about numerous times, prediction markets, although not perfect, do a remarkable job of forecasting the future. In this spirit, below is a time-series of the average of prediction markets regarding the likeliest election outcome.
As can be seen, the most likely case for most of the year was the Republican sweep (i.e., the solid red line) we got. There was some contention for the outcome of a Democratic president and split congress (the blue dashed line) for a period, once Harris replaced Biden. However, she lost steam toward the end of the campaign.
Similar in spirit to prediction markets, financial markets are also good (but not perfect) predictors of the future. Once election day came to a close, many US financial markets began to rally, reflecting the likely economic consequences of a Republican sweep. It turns out, based on history, this was not unfounded.
The above chart shows that years with Republican control of both the legislative and administrative branches, we tend to enjoy an additional US stock market return of 3% per annum. Although the sample size is small, it is certainly suggestive. We now disentangle why such election results can be a tailwind for the financial markets by linking some likely policies to outcomes.
Here come the Tariffs!
The most obvious and likely policy outcome going forward is increased tariffs, especially against China. Trump quipped the word tariff is “the most beautiful word in the dictionary” and refers to himself as “tariff man.” Tariffs were also a conspicuous part of his first presidency, as there was a dramatic set of tariffs set against China. Before looking at what happened then and what will likely happen this time, it is important that we first have a handle on how tariffs actually work.
Below is a diagram I created using Chat GPT that is helpful for understanding the process by showing an example of imposing a tariff on a Chinese import.
There are primarily three parties affected by tariffs levied against China: Chinese manufacturers, US import companies, and US consumers. While the US import company is the actual party paying the tariff, the effective payor of the tariff is some combination of the Chinese manufacturer (i.e., it can lower its selling price), the US import company (i.e., it can accept lower profits), and the US consumer (i.e., it can accept higher prices for the same good). The combination of who effectively pays what fraction of the tariff is a function of the elasticity of supply and demand, which is not trivial to estimate. Intuitively, who pays for the tariff will depend on the availability of substitutes for the US consumer and US importer to the Chinese good (i.e., other countries from which to get the good) and the availability of alternative customers to which the Chinese company can sell to. If the Chinese company doesn’t have a lot of other customers and/or the US consumer and importer can obtain goods and services from an alternative place, China is the one that mostly pays for the tariff. If the opposite is true, the US consumer will experience a significant price increase, which will show up in inflation.
What actually happened the last time tariffs were increased dramatically? Below shows a time series of Trump’s China tariffs, which were increased from an effective almost zero rate to around 16%. It’s important to note that the tariffs were changed across time as a function of negotiating and dealmaking.
The reason tariffs are typically used in the first place is to protect a country’s interests and induce more fair trade. How well did these tariffs accomplish this goal? Rand Corporation, an independent thinktank, conducted an in-depth analysis on the effectiveness of these tariffs and found the results were mixed. The chart below summarizes their findings. In short, they mostly worked.
Source: Rand Corporation report “The Effectiveness of U.S. Economic Policies Regarding China Pursued from 2017 to 2024.
What happened the last time around in terms of economic results? Specifically, what happened to inflation and the US stock market?
Below is a chart I created summarizing these results:
As can be seen, for this particular time, inflation was benign. The stock market actually did start to fall when the tariffs were introduced out of fear of a losing a trade war. However, the market quickly recovered and enjoyed two years of outsized gains during the largest tariff years.
What about this time in terms of tariffs and inflation? Indeed, Trump has promised even higher tariffs the second time around, which could introduce some one-time inflation. Note, however, that a tariff has a one-time effect on inflation and not ongoing one, assuming tariffs are not further increased each year. Below is a chart of the forecasted inflation rate based on the current expected tariff increases (blue dashed line) and a more extreme scenario (red dashed line).
Within 24 months, inflation should be normalized even under the more extreme scenario.
Another impact from increased tariffs is a strong dollar since fewer dollars leave the US, ceteris paribus. The following chart forecasts different currency changes under increased tariffs.
A likely outcome is for the dollar to be another 5-10% stronger than it is now, meaning it will cost about 5-10% less to spend money in other countries. This provides us with our first take away:
Takeaway 1:
Enjoy an international trip with a stronger dollar
Although tariffs are unlikely to threaten the returns on the US stock market, there will be new winners and losers, in terms of stock sectors. The below chart shows how different sectors had better or worse performance during the last tariff episode. As expected, more domestic facing (i.e., greater US vs. foreign sales) and defensive companies fared the best:
Similarly, smaller companies are likely to fare better with increased tariffs, as they tend to benefit from greater domestic sales. In addition, assuming corporate tax cuts are implemented, as discussed below, small companies tend to benefit more than larger companies. Finally, smaller companies are also likely to fare better in the near term due to reversion to the mean. Simply put, in recent history the gigantic companies have done better than most companies, which means stock indexes that report their return weighted by the size of its constituents fare better than those that weight their constituents equally (i.e., provide more weight to smaller companies).
The below chart I created shows how the difference between the SP500 cap-weighted (i.e., favoring larger stocks) vs. SP500 equally weighted (i.e., providing more weight to smaller stocks) varies over term and tends to mean-revert (i.e., average out). The chart reports the five-year total annual return of both the SP500 cap-weighted (SPX) and equal-weighted (SPW) over the last several decades.
Most recently larger companies have fared much better versus the smaller companies (i.e., SPX>SPW). However, many cycles have the opposite occurrence. There was even a larger divergence at the end of the late 1990’s of SPW vs. SPX, only to then be followed for the next decade of SPW dominating over SPX. The past decade has seen another reversal.
These three points provide another takeaway:
Takeaway 2:
Ensure sufficient exposure to smaller cap stocks
And this takeaway provides a corollary takeaway since the significant runup in large tech stocks has created many unbalanced portfolios:
Takeaway 3:
Rebalance cap-weighted exposures to reflect the recent cyclical returns
What else might happen?
Other likely policy changes are reduced taxes, both for personal and corporate tax payors, and reduced regulation. The net effect of these two forces tends to be greater economic growth. In fact, some have expressed concerns that we might have “too much” growth. However, the Federal Reserve ought to be able to balance this possibility through a slower glide path of lowering interest rates, in my view. As far as reduced corporate taxes, the largest companies mostly experience a 1-to-1 benefit to increased profits (i.e., if taxes are reduced 10%, they have increased profits by 10% of the previous tax bill), whereas smaller companies tend to have 20-30% more of a profit increase than the actual tax reduction. Finally, reduced regulation helps larger companies but smaller ones even more on average, as regulations tend to be a greater burden for smaller firms. This all, again, underscores the likelihood of smaller companies having a run going forward (i.e., takeaway #2!).
Reduced regulation also likely means a friendlier environment for mergers and acquisitions. This directly benefits private equity both by increasing the possibility of liquidating portfolio companies and finding additional deals. Private credit is often used to help finance deals, creating additional opportunities. This all increases the likely benefit of private investments.
Takeaway 4:
Consider an appropriate level of private investment exposure
As far as investments, from all of the above, it is more important than ever to rebalance factor risks in portfolios since recent gains have been uneven. This brings yet another takeaway.
Takeaway 5:
Rebalance factor risks to reduce risk and provide broad-based return potential
Finally, financial planning strategies are just as important value creators as investing ones. In this spirit, although now the current lower tax structure is likely to be extended by 2025, there almost for sure will be a variety of tweaks. As such, there will likely be an abundance of planning opportunities, from income tax to estate tax, to retirement to philanthropic planning. Stay tuned in the New Year for more on this.
Takeaway 6:
Link the coming changes to improved financial planning strategies and opportunities
And there will certainly be many other changes. Another significant change is immigration. Although the economic impact of immigration restrictions is likely to be muted, there are social policy implications. More broadly, there are likely also to be changes to health care and other programs, at least those linked to the executive branch. It seems Elon Musk will try his hand at cutting “waste” and improving government efficiency.
Whatever the net result, some programs are likely to be cut. In response to this likely course, one client suggested to me an interesting approach: take excess financial gains from the new policies and strategically invest this excess in targeted philanthropic programs. We have many clients interested in such an approach and look forward to combining these philanthropic plans with their overall financial plan in a smart way. Indeed, a back-of-the-envelope analysis shows this could raise some $150 million for charitable causes over the next four years, if every Omega client were to participate.
Some Final Perspectives
First, it turns out that our personal experience from president to president is actually more similar than we might realize. For example, Biden retained most all of Trump’s tariffs and recently proposed adding additional ones of up 100% on some items. Part of the reason for experiencing little actual personal change is that the president can only control so much. Congress is also crucial in bringing about changes. And much of the time Congress is split between its two chambers, meaning the status quo is what is most often is experienced.
This brings us to our next perspective. It is often the case a president helps sweep their parties control of Congress when first elected. However, after two years, Congress tends to become split again. This means most change is likely to happen in the first two years and then we return to the status quo. This happened under Trump’s last presidency. It also happened under Biden’s, Obama’s, and countless others.
For our final perspective, consider the following: although we make predictions, we can still know for certain what will happen in the next four years. For sure it is the case that…the years will provide an economic and market experience that is the status quo, terrible, or awesome! There is no other possibility. So, we want to make sure we have partitioned a portfolio to different pieces that can perform in these distinct environments. In doing so, you are liberated not to worry about your plan and instead find some ways to connect with your family and friends over these holidays. My guess is that you have some liberal ones and some conservative ones. My hope is for you to find the brains and hearts in both of them this season!
We look forward to seeing you during our next visit. In the meantime, Happy Holidays and we wish you a healthy and prosperous New Year!
Omega Financial Group, LLC is a Registered Investment Adviser. This commentary is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Omega Financial Group, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Omega Financial Group, LLC unless a client service agreement is in place.
