Few can quibble with the statement that President Trump has been the most disruptive President since World War II. By disruptive, I am not referring to style or personality but rather he has been the biggest change agent in the White House in my lifetime. He has reordered the tax code, moved away from globalism, dramatically altered immigration patterns, defunded various swaths of the Federal bureaucracy, and instituted the largest tariff infrastructure since the Great Depression.
Change by itself isn’t bad. A swollen bureaucracy, allowed to expand from one President to the next since the Clinton years, needed disruption. Piles upon piles of regulations became overbearing and needed to be dismantled. Besides using tariffs to pull manufacturing back to the United States, they also served as a revenue source to offset the costs associated with revamping the tax code.
Most times change has good intent. But disruptive change also has unintended consequences. From an investor viewpoint, the majority of changes to date have had positive consequences. Asset values have risen, inflation remains within a bounded range, corporate profits are rising at a double-digit pace, and lower short-term interest rates are coming. However, if you are not a member of the investor class, the picture isn’t as bright. The tax cuts embedded in the Big Beautiful Bill don’t apply to the 35%+ of our population that don’t pay Federal income tax. Over the past year, while inflation has moderated, cost pressures continue and are skewed toward necessities. Food costs are up 3.2%. Rents are up 3.5%. Medical costs are up 4.2%. Utilities are up 7.7%. And the cost to fix your car has risen 8.5%. These are not seasonally adjusted numbers. They are real and the burden is being felt.
Let’s step back and look at the conundrum. Tariffs are a tax that runs about $400 billion annualized based on current rates. The burden hasn’t been fully felt yet as businesses have been slow to raise prices to cover the full impact for fear of losing sales. Expect a bit more headwind in the second half of the year, but nowhere near the hurt feared in April when tariff rates were first revealed. In the second quarter, revenues rose at a 6% pace. Using 3% as a rounded inflation number, that suggests real growth of close to 3%, about triple the rate that could be accounted for by population and immigration alone. In other words, a healthy economy. Profits meanwhile rose by more than 10%. Margins obviously expanded despite all the uncertainty and any impact of tariffs on costs.
How do we square that circle? Housing activity was down. Car sales have slowed. Manufacturing activity has declined for 5 straight months. Capital spending is flat if I exclude the tens of billions being spent on AI related projects. Despite a weaker dollar, foreign tourism into the U.S. is down. So how can American businesses be doing so well?
The weaker dollar is part of the reason (more later) but the real answer is a weakening labor market directly due to corporate attrition that has served to lower unit costs. While few are being fired given that we are not in a recession, and memory reminds management of the difficulties replacing those talented workers previously fired, few are being hired. College graduates can’t find jobs. Technology related efficiencies are replacing middle management white collar workers. Job openings are down more than a third from their 2022 peak. 2-3 years ago, graduates were taught coding as an entrée to a lucrative job. Today, computers can do much of the coding. Undoubtedly seasonal hiring for Christmas will be a lot weaker than last year.
In the short run, savings achieved by skillful moves by management to keep or elevate margins from current levels will continue. But as I noted last week when talking about the weak August employment report, more jobs created is good and fewer jobs created is bad. There is no way to paint it any other way. Our economy’s foundation is based on Americans working full time and spending what they make. Machines can replace humans but machines have no purchasing power. Unless the displaced humans find alternative employment, storm clouds will start to appear.
I don’t want to sound overly pessimistic. Right now, the economy is slowing and the labor market is flat. That’s attention getting but it doesn’t mean a recession is pending. This week, the FOMC will likely lower the Fed Funds rate by 25 basis points and it could well do the same at the next 3-4 meetings if needed to reignite economic growth. No doubt lower rates will help stimulate growth as long as the labor market holds together.
Two more points. First, the dollar weakness. While the decline in the dollar’s value has moderated in recent months, it is still down 10% year-to-date. That means foreigners buying U.S.A. goods pay 10% less while import costs are 10% higher, excluding the impact of tariffs. That will reduce the balance of trade deficit and help to elevate reported GDP. But the real number within GDP that matters is final sales growth, growth less the impact of trade and fluctuations in inventory levels. That number is running well under 2% year-to-date. A lower dollar also serves as a disincentive to foreign capital spending, increasing the investment costs by the pace of the dollar’s decline.
Second, one of the positive unintended consequences of these disruptive policies is likely to be their impact on the deficit. For the year about to end September 30, the deficit is likely to be over $1.9 trillion. By some estimates, deficits could average over $2 trillion per year over the next decade. But there are important offsets. Tariff receipts could be as high as $400 billion above recent annual levels. They will reduce the deficit by their net increase. Second, the Federal debt, excluding holdings within government agencies like the Fed, is currently over $30 trillion. For every 1% reduction in the cost of debt, that implies possible savings of another $300 billion. That’s not a number that will be achieved soon given that it takes time for outstanding debt to roll over and longer maturities won’t necessarily fall at the pace of decline in the Fed Funds rate. But it is likely that, barring a recession in 2026, the deficit will fall, not rise. To be sure, a modest decline in the deficit of a couple hundred billion dollars won’t move the outstanding debt needle much. But it is a step forward. The real key next year will be whether Congress can actually attack Federal spending in a meaningful way. Members often talk the talk and then spend more anyway. A government shutdown is pending at the end of this month. Any extension requires 60 votes in the Senate. Democrats appear to want retention of government ACA subsidies as a price for their support. More spending. Look at the facts, not the political verbiage.
As long as the labor market hangs together without an appreciable rise in layoffs, stocks can keep moving higher. The Fed Funds rate will likely be lowered by 25 basis points this week. While some had hoped for a 50-basis point cut, last week’s CPI report decreased the odds of that happening, although there may be a couple of dissents. Investors will focus on how dovish Chairman Powell sounds in his press conference. Without being very analytical, markets simply love low interest rates. If Powell suggests in any way that a series of cuts are likely for several meetings, markets will respond very positively. But he is more likely to say that while a cut Wednesday is likely a start of a trend, the pace of rate cuts will depend on future data. Investors may also focus on the dot plots of how Committee members view the future. But over time we have learned dot plot predictions aren’t worth the paper they are written on. Just look at what you see Wednesday from the dot plots 3 months prior amid very small changes in actual economic activity. The impact of whatever the Fed decides this week will fade quickly as the data will dictate direction and the pace of change. The employment reports over the next two months, which will include the impact of Federal workers opting for early retirement, are likely to be more impactful than this week’s rate decision.
Today, Prince Harry is 41. Actor Tommy Lee Jones and director Oliver Stone both turn 79.
James M. Meyer, CFA 610-260-2220