Respect The Global Shifts In Fiscal Policy
Risk assets are coming off another tough week. The Dow tumbled 3.1%, the worst weekly slide in two years. The S&P 500 slid by -2.3%, and the Nasdaq Composite stumbled by -2.4%. All three indices hit six-month lows, with the Dow and S&P 500 have registered weekly declines for four straight weeks. The small-cap Russell 2000 fell by -1.5% last week in route to slipping to a seven-month low. This index has 85% of its revenues derived from within the United States and, as such, it is considered to be a bellwether market measure of where the domestic economy is heading — let’s say that with it down by roughly -8.5%, so far this year (and off by more than 16% from the post-election peak), the message isn’t constructive.
The S&P 500 and Nasdaq have slipped into official correction territory, with the former -10% off its February 19th high and the latter slipping nearly -14% from its February 21st high. At the same time, gold finally pierced the $3,000 per ounce plateau for the first time and is up more than +14% year-to-date – quite the contrast from the S&P 500 -4% year-to-date. From a short-term lens, the rally in gold does look extended, and I would not be surprised to see a consolidation phase from here or even a pullback. But this is an asset class I’m less inclined to get too caught up in trading the squiggles as the secular tailwinds for the shiny metal (copper too) remain intact. The upside potential to 2030 far outweighs the downside risks, so this remains one sector where dips should be bought.
As for the equity market, breadth metrics are approaching levels that, over the past five years, represented a thorough cleansing: below is a chart plotting the percentage of stocks in the S&P 500 (blue), Nasdaq Composite (yellow), and Russell 2000 (white) trading above their 50-day moving average.
Here is the same chart, but looking at the % of members trading above their 200-day moving average.
In addition to equity market breadth getting pretty washed out, market positioning among the CTA community has dramatically flipped. According to data from BofA, CTA’s have flipped to being short equities, to wit: “It’s been just 17 trading days since the S&P 500 and Nasdaq-100 reached their last new all-time highs, but after four consecutive weeks of declines, our model (which is based on both short-term and longer-term price trend) indicates that trend followers are now adding short positions in these markets.”
If this is nothing more than a run-of-the-mill correction, then we are nearing the depths of where the general equity markets should start to put in a bottom. But let’s not get too ahead of ourselves in declaring what this sell-off is, as there are a lot of crosscurrents at play that, depending on how they unfold, will matter to the direction/trend in asset prices. So far, we are getting confirmatory data that a ‘growth scare’ is underway as Wall St. houses are slashing their GDP forecasts. JPMorgan Chase reduced its Q1 and Q2 real GDP estimates to +1% from +1.8% for Q1 and +2% for Q2 earlier this year. Goldman Sachs cut its full-year growth projection to +1.7% from +2.4% (on a Q4/Q4 basis) – this is the first time the economics team at Goldman has been below consensus after several years of correctly forecasting U.S. GDP growth above consensus estimates.
Let’s move on to the meat of this week’s missive and the rising probability that a dramatic shift in fiscal policy settings worldwide is underway. When looking back at the economy and asset prices since COVID-19 hit in early 2020, the most significant variable driving growth, inflation, economic, and policy outcomes was the shift from monetary to fiscal dominance. Over the weekend, Keven Muir put out a piece on his Macro Tourist substack (Fiscal: The Best Source of Alpha) that I think is a must-read. Unfortunately, it's behind the paywall, but Kevin’s substack is more than reasonably priced and well worth the investment. Nevertheless, I’ll do my best to hit the highlights and provide some context for why I think this is the most important structural development for investors and markets since the mass adoption of passive investing.
The U.S. economy is undergoing what I believe is a significant transformation as policymakers aim to recalibrate fiscal policy to reduce the government's influence on economic output while unbridling the public sector to fill the void. On Sunday, Treasury Secretary Scott Bessent was interviewed on NBC’s Face the Nation, where he addressed concerns regarding government deficits and fiscal policy adjustments. In recent years, the U.S. has maintained historically high deficit levels, even in the absence of a war or recession. The current administration aims to bring these deficits down responsibly, ensuring a smooth transition toward economic stability, to wit:
“Kristen, it would have been very easy for us to come in and run reckless policies like before. We’ve had large government deficits—6 to 7 percent of GDP—we’ve never seen that when we’re not in wartime or recession. We are bringing those down in a responsible way. We are going to have a transition, and we are not going to have a crisis.”
While the market adjusts to these policy changes, Bessent remains confident that the worst-case scenario—a full-blown financial crisis—can be averted. He argues that an economic correction is preferable to maintaining unsustainable levels of spending.
“Could there be an adjustment? Yes. But if we had kept on the previous track, I can guarantee we would have had a financial crisis. I’ve studied and taught this. If we had continued with those spending levels, everything was unsustainable. So, we are resetting and putting things on a sustainable path.”
Bessent acknowledged the recent downturn and emphasized that stock market corrections, while unsettling, are an essential component of a healthy financial system.
“I’ve been in the investment business for 35 years, and I can tell you that corrections are healthy, they’re normal. What’s not healthy is a straight-up market where you get these euphoric conditions. That’s how you get a financial crisis. It would have been much healthier if someone had put the brakes on in ‘06 and ‘07, and we wouldn’t have had the problems in ‘08. I’m not worried about the markets. Over the long term, if we put good tax policy in place, deregulation, and energy security, the market will do great.”
For several weeks now, we’ve heard President Trump and a cadre of cabinet members deflect a litany of questions about the ongoing correction in asset prices and what impact their ‘flood the zone’ policy agenda may be having on them. Their collective response has been consistent in that they are not concerned; it is par for the course, and they have their sights on a bigger, more grand strategy. A strategy they admit could invite turbulence during the transition, but where they are convinced that the U.S. will be in a better place when we get on the other side.
At the center of the policy agenda is reducing the deficit (they even suggest they’ll balance the budget—give me a break) and using tariffs to restructure global trade in the U.S. 's favor. Many investors lack the proper context for just how large U.S. deficits have been relative to other major economies around the world, but they are double and, in some cases, triple almost everywhere else.
I’ve warmed to the concept that the massive fiscal stimulus post-COVID kicked the U.S. exceptionalism trade into overdrive. Have a look at the table below from Mr. Muir, which tabulates the total fiscal deficit as a percent of GDP since COVID-19—no other country is even close.
I don’t care to get into the debate on whether the spending was good or bad. Necessary or unnecessary. It is what it is, and it happened. Furthermore, I agree that what drives markets and the economy is never just one thing. Sure, there is a lot more to this equation than big fiscal deficits, and what I’m hitting upon is a drastic oversimplification of how things actually work. But I’m convinced fiscal stimulus was the most significant driver of how economies recovered coming out of covid where the U.S. outpaced everyone else in terms of the size of fiscal stimulus and economic performance.
However, we are reaching a crescendo where the appetite for more fiscal is waning, and a new administration is taking over where a drastic cut to fiscal spending is a top priority. Already coming into 2025, the rate of change of fiscal spending was set to slow. Still, based on data from a website called NASBO – National Association of State Budget Officers (hat tip to Vincent Deluard of StoneX for bringing this to everyone's attention), the extent of the slowing is pretty dramatic. This site tabulates all the different U.S. State Officers' actual spending plans and forecasts for next year. Below is a table of the data by calendar year where the falloff from 2024 to 2025 is breathtaking, +11.8% to -0.3%.
Look at the rate of growth in 2022 (+16%), 2023 (+6.3%), and 2024 (+11.8%). We last saw a similar downshift from 2007-2010 (the years bookending the GFC). I’m not suggesting we have another GFC in the offering, but the rate of change slowing in government spending, as we’re seeing coming down the pipe, is worth being mindful of. To be fair, I hear a lot of very plugged-in investors argue that DOGE and this administration won’t be able to cut spending in a meaningful way. A perfect example is the fact that the budget deficit is currently running above the level from a year ago. Moreover the ‘one big bill’ proposed by the house has little in the way of concrete cuts and actually adds to the fiscal deficit over 10 years if it were passed in its current form. However, I hold the view that Trump 2.0 is different than Trump 1.0 where Trump 2.0 is going to do what he believes should be done.
That is the case for tariffs, the other part of this administration's grand plan. Trump is showing no restraint in targeting our trading partners, whether allies or foes. Take Canada, for example, where, in the blink of an eye, we have gone from having a collaborative trading partner to one that feels threatened and pushed into a corner where they have no other choice but to stand up for themselves. As a result, Canada is taking steps to decrease its dependence on exports to the U.S., invest in pipelines to ship oil to other countries, build LNG terminals to sell its natural gas, and lower corporate taxes to incentivize more entrepreneurs to remain in Canada. Even if Trump were to come out tomorrow and say, “Just kidding,” it would be irresponsible for Canada not to protect itself from the threats this administration has made in the past couple of months – 51st state.
A similar thought exercise is playing out worldwide, with the U.S. leading the charge for every nation to “make themselves great again.” Germany gave in on its debt brake in order to subsidize increased military spending. Not to mention putting in additional fiscal incentives to resuscitate its beleaguered manufacturing sector. It’s a global pivot towards nationalism and a dramatic retreat from globalization. I’ll admit that no one has a stronger hand in this game than the U.S., but I’ll also admit that the U.S. potentially has the most to lose. However, that’s a missive for another day. For now, I want to stay on the market implications that investors need to be thinking about.
Back to Canada for a moment as the reports from the meeting between Canadian trade representatives and Commerce Secretary Lutnick were very insightful:
It is clear that this administration is not bluffing when it continues to reiterate that it intends to use tariffs to accomplish the priorities of meaningfully reducing the budget and trade deficit. Undoubtedly, the situation is very fluid and likely to experience dramatic shifts in policy from one day to the next (it’s almost like it's part of the strategy), but don’t lose sight of the end goal. Furthermore, don’t think that the rest of the world will step aside, twiddling its thumbs. They will react and we’re already seeing rumblings of this. Rumblings that jeopardize the U.S.’s standing as the world’s savings account. Foreign policymakers are making overtures that investment funds should shift capital back to local markets to capitalize national investment interests.
So, what if the rest of the world doubles its fiscal deficits going forward while the U.S. cuts its deficit in half (Bessant is on record as wanting to get it to 3%)? This would be a complete reversal of the past decade, where the rest of the world abandons austerity, and the U.S. adopts a mild form of austerity. This would suggest that economic growth outside the U.S. will have a fiscal tailwind and be stronger than the U.S. growth on a relative basis. Additionally, capital flows may shift to foreign markets in pursuit of better growth and cheaper valuations, as well as for national purposes.
Look, I’m not calling the end to U.S. exceptionalism or suggesting that U.S. equities are set up to crash. But since mid-February, I can’t deny that something has changed. It seems like every day for the last six weeks, I have seen foreign equities outperforming U.S. equities on both up days and down days. To me, this indicates that incremental capital is matriculating to foreign markets and not U.S. markets. Similarly, the U.S. dollar is falling, and U.S. interest rates remain stubbornly elevated in the face of economic and inflation data suggesting they should be falling. This potential shift that is underway is not something that will run its course in a matter of a month or a quarter; there is the potential for this theme to take years to play out. If it is truly taking shape, then it argues that everything that has worked over the past two decades is at risk of reversing in the foreseeable future. I don’t mean a 180-degree reversal, but rather that U.S. stocks aren’t the only game in town. Perhaps it's already started, which is why gold has outperformed the mighty S&P 500 over the past 12, 24, and 36 months. Or why European markets, while not lighting the world on fire from a fundamental perspective, have been outperforming U.S. stocks since Trump's election victory in November. The same goes for China and emerging markets generally.
Bottomline, things have changed in the last two months. Whether it’s a good change or a bad one is up to everyone to determine for themselves. What I see in the data, policy maneuvers around the globe, market prices, and capital flows is an acknowledgment of something changing. From an investment standpoint, I think there is enough ‘there, there’ for investors to take some tactical action. I’ve been incrementally increasing portfolio exposure to foreign markets for the last several weeks. Additionally, if the rest of the world (including China with recent announcements) is ready to step on the fiscal accelerator, that should provide a reasonable tailwind to global commodities. We already have some exposure to oil and gas, nuclear, and uranium on the books, but base metals (copper in particular) are an area I’ll be looking for when the opportunity presents itself.
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