Contradictory goals create tension. Look at immigration policy. The stated goal to increase arrests to 3,000 per week is in conflict with the goal to allow farms, landscapers and construction sites to keep and maintain work forces necessary to maximize production. Tension can only be released if a happy median can be found.
Within the economic world several contradictory goals have been set. Tariffs are being used as a tool to reduce or eliminate balance of payment deficits. But they also serve to slow growth, being a tax equivalent. The reconciliation act passed on by the House to the Senate is clearly designed to stimulate growth via large tax cuts and increased deficit spending. But higher deficits, combined with tariffs, are likely inflationary.
To simplify the picture, Congress at the most macro level is dealing with two contradictory choices. It can stimulate more growth by increasing the amount of tax reduction and through higher spending, or it can try to reduce future deficits by reining in spending or reducing the scope of tax cuts to harness some form of deficit control. When Congress reins in spending, those losing Congressional handouts will scream. At the moment those screams are loudest from recipients of Medicaid and SNAP funding. But what Trump labels the big beautiful bill is going to expand deficits and elevate the amount of debt the government will have to service. Any pain from such actions won’t be felt immediately and Wall Street would likely embrace passage, at least close to its current form. But that assumes the bond market doesn’t rebel.
The Trump remedy is for the Fed to lower the Fed Funds rate by at least a full percentage point. Given current net debt outstanding today of over $30 trillion, most of which matures inside of two years, there would seemingly be a significant decrease in future debt service. But that only works if inflation stays under control allowing interest rates to stay low. Lower rates won’t likely attract more buyers of bonds. Moreover, if the total debt outstanding increases by more than 50% over the next decade as the non-partisan Congressional Budget Office predicts, debt service will skyrocket unless interest rates can be kept near zero as they were for an extended period post the Great Recession. Again, that is unlikely given the amount of bonds Treasury will be forced to issue and refinance.
In reality, virtually everyone agrees that allowing deficits to spiral upward over the next decade will eventually lead to dire consequences. At the moment, Federal expenditures are running at a pace of a bit over $6.5 trillion. Debt service alone is running at a pace of over $1 trillion. That’s over 15% of spending. Can anyone run a business successfully with debt service of more than 15% of revenues? If debt swells to $55 trillion in a decade and I assume an interest rate of just 3%, debt service requirements would leap to $1.65 trillion. If I assume the growth rate of government spending could be kept to just 2% annually (which would include the impact of higher interest expense), debt service would exceed 20% of the Federal budget. If I use a 4% cost of debt and a 3% inflation rate for government spending, interest would account for 25% of total spending. Clearly, allowing deficits to continue at the pace predicted by the Congressional Budget Office assuming passage of the current bill, is unsustainable.
Yet, put yourself in Trump’s shoes. He has 3 ½ years left in his term. Does he want to be the ogre that takes money out of everyone’s pockets? Does he want to limit spending that will keep overall GDP growth at a sub-par rate? And finally, does he want to even consider reining in Social Security or Medicaid? Even if he sees the problems coming in future years, if he can ride the wave for just a few more years and leave the solution to the next guy, why not try?
The one truism about Congress, at least Congress of the 21st Century, is that it takes a crisis to provoke a response. With no current crisis apparent, the likelihood is that Congress is going to pass the reconciliation package with only modest changes and deliver a final package to the White House sometime before mid-summer.
The package will be stimulative and offset much or all of the pain of tariffs currently in place. In the short-term, that will be viewed as positive by investors. Until the bond market rebels and lifts long-term rates significantly higher, investors are unlikely to look past the impact lower taxes and higher spending will have on near-term earnings.
So far, we have left the economic impact of immigration out of the discussion. But it cannot be ignored. For all the headline bluster, the number of deportations to date lag behind 2023 and 2024 levels. But that is misleading because a substantial number of Biden deportations were of people who illegally crossed our southern border and were quickly sent back. While over the past few weeks, ICE apparently stepped up efforts to arrest and deport individuals at a faster pace, the actual process is both expensive and time consuming. Warrants are generally required, the recipient nation(s) of deportees have to be willing to accept them, transportation has to be arranged, and ICE has to deal with court intervention. Even with all that said, the net number of immigrants to the U.S. is sharply lower than it has been over the past two years. While some like to picture all immigrants as lazy criminals sponging off of our welfare system, the vast majority want to work. They make money, pay taxes, and buy consumer goods and services. Economically, they are additive to GDP. Immigration has added roughly a percentage point a year to GDP. Again, I chose not to deal with the non-economic issues related to immigration. That’s beyond the scope of my letters. But assuming immigration is cut in half (or more), the incontrovertible fact is that immigration policy today is a net negative to growth.
It is also clear that immigrants often do work that most Americans don’t want to do including picking crops, cleaning hotel rooms, and washing dishes in restaurants. Hence, we heard from the White House last week that deportations, at least for now, should focus on those who have broken the law or otherwise abused their welcome.
Thus, we face a variety of tensions caused by conflicting goals. Faster growth versus allowing debt to skyrocket. Deportation versus the need for labor in key economic sectors. Tariffs versus tax cuts. What we have seen so far, whether it be Liberation Day tariff announcements, wholesale DOGE firings, or rounding up immigrants seeking day work at a Home Depot parking lot, are cases of two steps forward and one step back. Even Musk said early on that DOGE would make mistakes; it was important to fix them quickly. Although tension generates angst, which set off a brief but rapid market decline this spring, once tensions started to moderate, order on Wall Street was restored.
Investors seem to have embraced the overall game plan acknowledging that there would be bumps along the way. Until 10-year Treasury yields spike above 5% or the dollar craters sending world financial markets into turmoil, the focus will be no recession this year and stimulative growth next year assuming the reconciliation bill passes.
As always, however, one can’t sound the all-clear siren. Complacency is rising as is speculative fever. IPOs are coming at an accelerating rate and opening up as much as 100% or more above issue prices. Wall Street is striving to find ways to move private equity into public hands, at inflated values in many cases freeing up capital for new investments. The public, anxious to participate, are buying high profile names without any substantive financial information. Sounds like the SPAC era of 2021 which ultimately ended badly. All episodes of market euphoria end badly but euphoria can last for months or even years.
Thus, for the short-run, enjoy the ride. But recognize that markets take the escalator up and the elevator down. Euphoria, built on a bedrock of complacency, is additive. But it won’t last forever.
For those of you with economic backgrounds, you may want to note that Adam Smith was born on this date in 1723. As for today, Phil Mickelson turns 55.
James M. Meyer, CFA 610-260-2220