The Senate appears ready to send its version of the “Big Beautiful Bill” (BBB) back to the House to either accept its changes or to make further modifications. While President Trump wants to see the bill on his desk for signature by Friday, there is a lot to do in four days for that to happen. Should passage slip a few days or even a week or two really doesn’t matter as long as something gets over the finish line.
Everyone can agree the bill is big. But beauty is in the eye of the beholder. As Congress usually does, the fiscal takeaways never seem to equal the fiscal giveaways. The Senate version is even more expansive than the House bill. One can argue exactly how to score the bill, but whatever gets done is likely to expand our total debt by well over $20 trillion and perhaps by more than $30 trillion over the next decade.
We have discussed the implications of carrying such a large debt load before and don’t want to repeat them today. Rather I want to look at the shorter-term implications and tie them to the market’s current behavior.
The first thing to note is that deficit spending increases both GDP and the growth rate. There isn’t an exact one-to-one correlation because transfer payments, such as SNAP outlays don’t count in the GDP calculation. But clearly the BBB is going to increase economic activity at the expense of increasing the debt load.
One of the open issues is tariffs. Last week, Trump again rattled sabers aiming at Canada. The July 9 deadline for the extension of the so-called Liberation Day reciprocal tariffs is a little over a week away. While no one expects full implementation, how Trump will segue into an updated tariff regime is an open question. No matter how tariff talk is spun, tariffs are a tax, a depressant to GDP. On the other hand, expanding tax breaks and making the 2017 tax cuts permanent will be an offset, probably resulting in a net positive. The dollar today is at a four-year low against the euro and has fallen persistently since Trump’s inauguration. A weak dollar makes imports more expensive while decreasing the incentive for foreigners to buy U.S. goods. That reduces the balance of payments deficit, a top Trump priority.
But there is also a downside to a weak dollar. It reduces the incentive for foreigners to invest in the U.S. In general, fluctuating currency values serve to level the playing field allowing weaker economies to stay competitive with stronger ones. Capital generally flows from weak to strong. Besides the dollar’s weakness, another factor affecting fund flows has been the increase in bond yields in key foreign markets, notably in Germany and Japan. For years, foreign investors have been investing in the U.S. because yields on U.S. debt were higher and the U.S. economy was considered the world’s safest and strongest. But the dollar weakness erases those gains. Even with the use of currency hedges, those contracts get more expensive if buyers perceive ongoing dollar weakness. The net result is that foreigners are considering lowering their U.S. exposure at a time when our deficit-to GDP ratio is at a record high excluding wartime and recession periods. Japan owns more U.S. debt by far than any other nation. As yields on Japanese bonds rise, the temptation to invest locally rises as well. While Republicans insist the BBB will reduce deficits from the current 6%+ of GDP toward a more sustainable 3% over time, many are rightfully skeptical that is achievable.
Against this backdrop, the Fed is likely to start lowering interest rates this fall. Current estimates of GDP growth in the second quarter range from 2-3%, close to normal. Unemployment rates of a bit over 4% signal a strong labor market. While one or two quarter point cuts in the Fed Funds rate appear reasonable, calls from the White House for swifter and larger cuts seem imprudent. If one’s focus is on growth maximization, zero interest rates are the extreme. When borrowing costs are zero in nominal terms and negative in real terms, the rush to borrow, build and invest are obvious. But what happens is that a lot of dumb stuff happens. That’s how we end up with zombie office buildings and shopping centers, and how China ended up with a massive oversupply of apartments. While a prudent Fed isn’t going to lower rates to anything near zero anytime soon, even a one full percentage point reduction in the Fed Funds rate risks elevating inflation once again.
Market observers have focused on the inflation rate that approached 9% post-Covid. But asset inflation had been going on for well over a decade. It wasn’t visible because it wasn’t goods and service prices that were escalating fast. Rather it was real estate and equity prices that were inflating. Inflation is a monetary phenomenon that arises from imbalance. When more money is facing fewer goods, prices rise. When more money faces fewer homes, home prices go up. When the Fed does quantitative easing pouring more money into the economy using banks as the conduit, stock prices go up. This wasn’t just a post-Great Recession event. After the Internet bubble burst, Fed Chair Alan Greenspan expanded money supply similarly leading to the greatest boom-bust housing market of our lifetime.
From late 2022 to the spring of 2024, the Fed actually shrank the money supply as it sought to defeat rapid inflation. But today, it is growing money supply once again at a 5% rate. That seems about fair given nominal growth of 2-3% and inflation of 2-3%. But if the Fed starts lowering rates, the likelihood is that is going to be accompanied by more rapid growth in the money supply. Whether inflation reappears in the price of goods and services, or in the value of assets like homes and stocks is an open question.
If the BBB inflates GDP growth and easier monetary policy leads to higher asset prices, investors will celebrate. Hence record stock prices and a more euphoric investing environment. What’s the downside? Markets can overheat, bubbles will appear and eventually burst. When could that happen? Probably not this week. But there are signs that euphoria is expanding to dangerous levels. Circle, which supports a stablecoin platform, has more than quadrupled in price in weeks following its IPO. Expect many more crypto-related IPOs in the very near future. The rebound to record prices by key Mag 7 names opens the door for new offerings as well. Witness the dramatic performance of CoreWeave. The IPO calendar has been severely reduced since 2021. But now it is growing rapidly. New platforms are being developed to package private equity investments into vehicles that can attract the small investor. Private companies must file financial statements with the SEC once they reach a set number of shareholders. But if a fund can be created that will have thousands of investors but represent only one shareholder to the private equity company, perhaps those rules can be evaded. Today, in private markets, accredited investors can buy stakes in high profile names like SpaceX without any access to financial information. These all represent seeds for a bubble that will eventually burst, but the moment of eruption could be weeks, months or even farther into the future. Equity markets are governed by the same laws of supply and demand as everything else. When IPOs are infrequent and companies actively buy back stock, the balance shifts toward reduced supply and prices rise as a result. But as we saw in 2021 when a spate of SPACs and IPOs inundated markets, too much of a good thing leads to a correction in price. All we can say for now is caveat emptor.
In the meantime, we are at the cusp of second quarter earnings reports and passage of the Big Beautiful Bill. Investors are likely to enjoy both. Stocks have been on a tear over the last 60 day. So, we may be in for some “buy the rumor, sell the news” consolidation over the next few weeks. Whereas investors were very gloomy when Q1 earnings were reported just as peak tariffs were announced, today the mood is quite different, almost euphoric.
Ultimately, valuation matters. Stocks aren’t quite back to the lofty P/E levels of late 2021 but it is hard to say that they are bargains. The ratio of stocks trading above their 50-day average is at levels suggesting some consolidation may be forthcoming. Not a big shakeout, but enough to reset values to a point where some bargains can reappear.
Today, swimmer Michael Phelps turns 40. Mike Tyson is 59. Ron Swoboda, one of the original NY Mets, is 81.
James M. Meyer, CFA 610-260-2220