Push and Pull
Among all the ‘sturm and drang’ from the Trump administration, it's little surprise to see the major averages chopping violently while making little progress in either direction. The S&P 500 first crossed the 6,000 threshold back on November 11th, and here we are three months later, with the S&P 500 trading a little over that level. The small-cap S&P 600 is at the same level it was in mid-September, and this was supposed to be the part of the equity market widely expected to be the main beneficiary of the MAGA policies.
I guess it all depends on how an investor wants to look at things: hey, we are still above 6,000 given the rise in uncertainty, so so earnings results, the Fed pausing its cutting cycle, and economic growth modestly cooling (‘the realists’). Alternatively, an investor might conclude that after a multi-month window of consolidation, the equity market is poised to kick off its next leg higher on the promise of pro-growth fiscal policy (deregulation, tax cuts, and DOGE) coupled with solid earnings, interest rates leveling off, the Fed having room to maneuver, and economic data holding firm (‘the optimists’). A pessimist can take the other side of everything in the prior sentence and conclude that equities are set up for a 10-15% correction on the next legitimate negative catalyst.
If I were forced to pick, I’d put myself in the first camp with an open mind on joining one of the other camps if/when the data, a policy announcement, or other significant catalyst were to materialize that justified a switch. In the meantime, remaining patient, diligent, observant, and calibrating one's noise filter seems like the right vantage point to have at the moment.
Like it or not, headline noise will be part of the fabric of markets and policy, and this administration will have to successfully navigate a dense minefield to achieve its ambitious agenda:
Rich equity valuations
Unemployment rate at 4.1% (that’s a good thing, but doesn’t leave much room for improvement)
Bloated deficits that need to be reigned in
Government debt refinancing schedule that is crowding out private investment
Globalization retrenchment
Sticky inflationary pressures
Razor thin majority that will make it tough to get meaningful legislation passed
On the trade front, it looks like this administration is pursuing a tactical and/or transactional trade dispute with most regions around the world, with the exception of China. With China, the trade confrontation is strategic, but it appears as though both sides are aware that there is a lot at risk and perhaps too much to lose with a significant escalation in a U.S.-China trade war.
I know this may seem like a controversial statement to some, but let’s assume that Trump is genuine in his MAGA proclamation: he wants to level the playing field with our international trading partners in the interest of creating jobs, reorienting supply chains on the grounds of national security, and force both allies and adversaries to pay more for access to the largest economy in the world. In addition to shaking up the Global World Order as it is currently structured, the Trump administration has made it a priority to extend the Tax Cuts and Jobs Act (TCJA) that was passed at the end of 2017. The fundamental dilemma for the GOP in extending the TCJA is that there are very tough tradeoffs that need to be made in order to get the math to work.
Donald Schnieder, Deputy Head of U.S. Policy at Piper Sandler, published a thread on X last week detailing how difficult it will be to find the money to fund an extension of the TCJA. Below is a graph plotting the deficit path based on estimates of GDP growth and revenue from the Joint Committee on Taxation (JCT) if the TCJA is extended (orange line). Also plotted on the graph are the estimated impacts of various levels of spending cuts ($500 billion, $2tn, and $5tn). What is clear is that anything less than $2tn in spending cuts will have a de minimus impact on the deficit - $2tn in cuts simply keeps the current level of deficit / GDP stable.
Here is the same chart zoomed in on recent history. The bottom line is that we need much more spending restraint just to keep the deficit in check if Trump and the GOP want TCJA fully extended. Frankly, we all should want the 2017 tax cuts extended; if they are not, then the U.S. economy is looking at the largest tax hike in history. I don’t care how fiscally conservative you are; a tax hike of this size would significantly crimp consumers' pocketbooks – a consumer, I might add, that is the driving force behind U.S. economic growth – and risk pushing us into a recession. Ironically, a recession would cause asset prices to fall, as well as tax revenues, and more than likely, it would make our fiscal situation even worse. So, really, it’s a matter of what deficit path you want.
Recent estimates put the cost of extending the TCJA at $4.6 trillion over the next decade. While controversial to some, the DOGE department will find some cuts, but at the end of the day, it will come up well short of the offsets necessary to make the scoring work to extend TCJA. This is where tariffs come in for Trump, as he needs them as a revenue source to defray the cost of his fiscal plan. Those wanting to do the math at home can use $4tn (see chart below) as a rough estimate for the total amount of imports (goods and services) into the U.S. A 2.5% tariff on all imports would add $100bn in additional revenue, 5% would equal $200bn, 10% is $400bn…keep in mind there would be negative impacts that would have to be incorporated into the macro model which would lower the tariff revenue, but you get the basic point. A 10% tariff on all imports over 10 years would raise $4tn in revenue, but such a rise will without question invite reciprocal action from our trading partners, and this is where things get really complicated.
Figure 1Total Imports (goods and services)
Makes you wonder if Trump had this challenging math on his mind when he made the following comment over the weekend questioning the total amount of U.S. treasuries outstanding:
"There could be a problem - you've been reading about that, with Treasuries and that could be an interesting problem."
"It could be that a lot of those things don't count. In other words, that some of that stuff that we're finding is very fraudulent, therefore maybe we have less debt than we thought."
Or maybe Trump, coming fresh off his meeting with Japan’s PM, is trying to shift the lens through which investors look at U.S. debt to a Japanese perspective. Japan is the most indebted country in the world, but Japan's MOF (Minister of Finance) and its central bank own over half of the JGB’s (Japanese Government Bonds) outstanding. Therefore, raising the question, if the government owns the very debt it issues, do they have to pay it off, or can it just cancel each other out? Below is a graphic illustrating how much U.S. Treasury debt is held by the Fed and inter-government agencies, where a similar question can be asked – does the government really need to pay itself back?
As for the week ahead, all eyes (and ears) will be on Fed Chairman Powell’s semi-annual congressional testimony on Tuesday and Wednesday. On Wednesday, we get the CPI data for January, which is always a tough month to predict since so many items on the services side, especially insurance premiums, reset at the start of every year. The consensus is taking on a lot of caution, expecting a pair of +0.3% prints on headline and core, which will likely cement the market’s view that the Fed is going to be on hold at the very least through the first half of 2025.
Last week's solid jobs report did nothing to alter the market expectations that the bar is ultra-high for any more rate cuts this year. Investors now see just 8.5% odds of a rate cut at the March 19th Fed meeting, down from 16% on Thursday. The odds of a rate cut at the May 7th meeting slumped to 29% from 39%. For June 18th, the odds were trimmed to 57% from 65%. And now the markets are priced fully for just one -25 basis point cut for all of 2025 — down to 47% odds of seeing -50 basis points in total rate reductions, down from 58% at Thursday’s close.
It's surprising to me to see gold performing as well as it is with the Fed moving to an extended pause, the dollar holding firm, and U.S. fiscal policymakers at least acting like they want to reign in government largesse. None of this has mattered to the yellow metal, which is making a new all-time high today, trading above $2,900/oz while gaining +10% already this year. Over the past 12 months gold is up +40% compared to a +22% gain for the S&P 500. Over the past five years, gold is up over +80% (S&P 500 is +80% as well); over the past decade, gold is up nearly +130%, and it is up +825% since the turn of the century – handily outpacing the +555% total return in the S&P 500. It’s easy to get caught up in the excitement of the stock market and how great of a compounder stocks have been for investors over the past fifteen years, but this just goes to show you that tangible assets like gold or real estate are a great complement to owning stocks. Real assets are a great risk management asset to protect one's wealth against currency debasement over time, which we’ve experienced a lot of since the GFC.
As for some closing thoughts, last week we got through the last earnings report for the 35% of the S&P market cap that we call the Mag7. As a group, the earnings were okay, it's just hard to raise the bar any higher than it already is for a group that is trading at a forward P/E multiple of 30x or 50% higher than an already rich 19x multiple for the S&P 493. The four biggest spenders on the data centers that power artificial intelligence systems all reported last week that they would step up their capex budgets further in 2025 after record outlays last year – Microsoft, Google, and Meta Platforms have projected combined capital expenditures of at least $215 billion for their current fiscal years, which represents a +45% annual surge. Meta and Amazon are the only two Mag7 stocks positive on the year.
While none of them backed away from their capex commitment to the ongoing AI arms race, we are starting to see some fatigue set in on how much more capital they are willing to commit without gaining a firmer line of sight on what the ROI is going to be for all this investment. Without question, these companies deserve the benefit of the doubt from investors as they have proven throughout the years that they monetize ideas better than anyone else. But history is littered with examples showing that investors are rewarded for investing in capital-starved opportunities, not the other way around. There is a risk that we are seeing too much capital investment that will undermine the long-term return potential for most of the players in this arms race. I’m not questioning the long-tail potential of the AI renaissance that’s underway, but I do believe it will evolve through a series of fits and starts, with 2025 marking the start of a digestion period.
Beyond that, I wish I had something juicier to share, but I don’t. I think a diversified portfolio of high-quality stocks, a combination of fixed-income instruments across credit quality and duration, some commodity exposure, precious metals, and a healthy dose of cash/cash equivalents will work well in the current environment. Stay humble, remain patient, and continue to prepare to act upon opportunities as they present themselves.
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