Friday’s solid employment report, a bit above Street expectations, sent stocks and bonds into a tailspin. Stock prices fell about 1.5% while 10-year Treasury yields spiked to over 4.75%. While an ongoing robust increase in employment could be inflationary, there are no convincing signs that is happening yet. Maybe we will learn more when CPI data is released this week. Unemployment at 4.1% is still above the cyclical low of 3.7% and wage rate increases, combined with productivity improvement of over 2%, suggest inflation is still on a path that moves slowly toward a 2.0% target. It might not get there, but the problem isn’t the labor market, at least not yet.
That is not to say that inflationary pressures aren’t real nor is the rise in Treasury yields out of line. After celebrating a Trump victory with eyes on lower taxes and less regulation, investors have shifted focus to other parts of the Trump economic game plan. Reshoring, a deficit inflating tax bill, deportations and tariffs each have inflationary possibilities. The offset is DOGE but even Elon Musk admits the 10-year $2 trillion target is aspirational and best case. And DOGE hasn’t even started.
Let me start with deficits. The size of the Federal Deficit is hard to comprehend. Trying to give some perspective, our gross Federal debt is $36 trillion. Our population is roughly 340 million. Debt per individual, therefore, is over $105,000. For a family of 4, that is fast approaching half a million dollars. While no one is asking any of us to repay that debt, collectively via taxes we have to service it, i.e., pay the interest. In the current fiscal year, that is close to $900 billion, more than we spend on defense. We now spend about 13.4% of the Federal budget on interest payments. If the government can simply keep deficits at current levels, debt service payments will rise another 5.5% this fiscal year. That assumes interest rates remain flat.
Let’s use a different lens to give this some perspective. A 1% change in the rate paid on $36 trillion in gross debt outstanding would be $360 billion, almost twice the annual aspirational savings from the Musk/Ramaswamy DOGE task force. The $360 billion is almost certainly too high given that most Federal borrowing is at the short-end of the curve, the $36 trillion is a gross number that doesn’t take into consideration debt held by government entities like the Federal Reserve, and a 1% annual change across the yield curve is probably too high. But even if the increase in debt service is simply 5% reflecting just the increase caused by next year’s projected deficit, we are talking about close to $50 billion added to debt service costs just this coming year. As for the DOGE goals, while savings of $100-200 billion per year might be doable, such savings may not offset the combined increases in debt service, Social Security and Medicare payments.
Debt service isn’t the only inflationary factor. In Economics 101 we are taught theories that stem back to the time of David Ricardo and reemphasized by Paul Samuelson that globalization leads to a most efficient cost structure. In essence, a country should make what it can most efficiently and buy the rest from others who can produce goods at a cheaper price. But in recent years, the economic efficiency of globalization has increasingly taken a back seat to the security of the supply chain and geopolitics. Today, countries are redesigning trade policy to ensure adequate supply. The tradeoff is higher costs. That’s inflationary.
Next consider labor markets, immigration and deportation. The aging of our population puts persistent downward pressure on labor participation rates. The offset during the Biden years was a sharp rise in immigration. That has already started to change and Trump policies will slow the flow to a trickle. There will still be seasonal workers to pick crops and visas issued for workers in key industries. But it will also mean higher wages for lower-level jobs. The impact doesn’t have to be huge. For industrial businesses, labor is about 10% of costs. But in commodity sectors like food, it’s higher and will be reflected in price.
Likewise, the impact of tariffs on inflation should be less of a burden than fearmongers expect. For one, Trump often threatens to cajole nations to behave differently. Threats are often more effective that actions. Even when tariffs are imposed, they are often more moderate than pronounced initially. With that said, tariffs will still be a modest headwind.
That leaves tax legislation. While Republicans would love to have one all encompassing bill that can be passed via reconciliation covering everything from Federal spending to taxes, the almost certain reality is that the parts that prove most controversial or more difficult to reach consensus quickly will be stripped out for later consideration. Taxes fit into that category. The Trump team would love to get a tax package completed before the honeymoon period is over but its complexity and its impact on debt and deficits likely will make that difficult. There is no question that the wish list of the campaign, passed in its entirety has little chance of passage. The key is how much has to be sacrificed and how much will Congress allow annual deficits to expand.
The arbiter will be the bond market. Just last week I noted a recent survey by a prominent brokerage of institutional clients gave only a 5% chance that the 10-year Treasury yield would be over 5% by the end of 2025. If that same survey were taken today, only two weeks later, I am sure that percentage would be well over 10%. And it is worth noting that there has been no substantive inflation data released over that two-week period that would impact opinions.
Today, the 10-year Treasury yield sits at just over 4.75%. The earnings yield (earnings divided by price, the inverse of P/E) on the S&P 500, based on 2025 projected earnings is about 4.5%. Compare that to the 10-year Treasury yield. Does it make sense? As long-term yields rise and the earnings yield falls (as P/Es continue to climb) there is an obvious disconnect. The discrepancy may not self-correct immediately but history suggests that it is rare for Treasury yields to exceed equity earnings yields for an extended period of time. We have made the point many times that equity P/Es are well above historic norms. There is an old expression on Wall Street that stocks take the escalator up and the elevator down. No mention as to how long the escalator ride continues but the discrepancy won’t last indefinitely. Should Trump’s economic agenda progress smoothly and deficits stay at or below current levels, the ride up can last for some time. But if markets sense any economic imbalance, a sharp and swift correction can ensue. The only factor that could mitigate the severity of any correction is the likelihood that both GDP and earnings will continue to rise in 2025. Thus, we aren’t talking about a huge bear market but rather a valuation adjustment. That could still be painful.
We have said repeatedly that the most important determinant for stock prices at the end of 2025 will be the yield on 10-year Treasuries. Perhaps the most important factor influencing that number will be the outcome of tax legislation and the perceived impact on the size of future deficits. Last Friday’s employment report is a reminder of how sensitive markets are becoming to bond yields, deficits and the future path of inflation. The future isn’t all negative. For one, adding 250,000 jobs in a month can only be a positive for both GDP and earnings growth. Technology, including the implementation of artificial intelligence tools into our economy is likely to keep productivity growth above average, offsetting any ensuing wage pressures and other inflationary factors. The notion that the Fed is done cutting rates isn’t a real negative. Rather, should that come to pass, it suggests economic balance with steady growth and modest inflation. Isn’t that the Fed’s charter?
The stock and bond market skittishness suggests reality is sinking in. Optimistic projections of DOGE savings barely offset added debt service costs, for instance. It is also realistic to assume that some of the tax goodies in Trump’s proposed package will have to be sacrificed in the absence of offsetting ways to increase revenue. Getting anything done in the new Congress will be a struggle. Uncertainty is the enemy of financial markets.
Finally, I want to address the California fires, a tragedy of epic proportions that no one can fully grasp at the moment. Without trying to suggest causes or place blame anywhere, the reality is that impulsive decisions to rebuild are going to be difficult to execute. Moreover, the costs to be borne by the citizens, the city of Los Angeles and the state of California are likely to be enormous, even if Washington kicks in. The increased cost for insurance alone will drive many Californians elsewhere. This saga will take years to unfold. Hopefully, steps can be taken to limit future risks but the facts are that thousands, if not millions of people in California live in a state with limited rainfall from late winter until late fall, an obvious setup for more disasters. Codes will change and steps will be taken to mitigate future risks. But until states elevate concerns relative to natural disasters higher on their agenda, the end result is likely to be an accelerated exit of population to other states.
Today, Orlando Bloom is 48. Actress Julia Louis-Dreyfus turns 64.
James M. Meyer, CFA 610-260-2220