Competition Shocks, rival reactions and return comovement

We estimate changes in within-industry stock-return comovement caused by the reaction of rival firms to significant tariff cuts. In theory, rivals react by either increasing or decreasing product differentiation. Increased differentiation lowers cash flow correlation and return comovement, while reduced differentiation increases comovement. Large-sample tests show that tariff cuts in manufacturing industries increase comovement and more so for within-industry ‘followers' than ‘leaders'. The notion that this comovement-increase reflects efficiency-enhancing rival reactions is also supported by evidence of increased cost-efficiency measures. One channel for this efficiency-increase is M&A activity among industry followers.