Equities Chase Headlines, Bonds Chase Data

Executive Summary

• A U.S. government fiscal cliff is, in our view, one of the biggest risks for equity investors. We believe a negative resolution will arrive sooner than current consensus expectations.

• The bond market appears to be reacting more prudently to eroding fundamentals, while equities remain surprisingly sanguine. Historically, when bond and equity markets diverge, bonds tend to be right.

• The U.S. spends too much, collects too little, and carries too much debt. With a deficit of 6.5% of GDP and federal debt at 120% of GDP, the U.S. ranks among the weakest fiscal profiles in the OECD.

• To refinance ~$9 trillion in maturing debt and fund a ~$2 trillion deficit, the Treasury must issue debt equivalent to nearly 10% of global GDP—an enormous task that hinges on robust investor demand. Recent policies, including tariffs and the budget bill, may erode that demand.

• Section 899 of the Budget Bill (“OBBBA”) could significantly raise borrowing costs by provoking foreign retaliation or reducing foreign participation in Treasury auctions. We expect this clause to be removed or heavily revised.

• We remain cautiously positioned: overweight cash, short-duration high-grade debt, and defensive sectors with strong dividend profiles, particularly in domestic service industries.

Twenty-Five Years Since a Balanced Budget

From the end of WWII until the early 2000s, the U.S. generally ran counter-cyclical budgets: surpluses during expansion and deficits during downturns. Notably, the late 1990s concluded with four consecutive budget surpluses, ranging from 0.8% to 2.3% of GDP, with real outlay growth under 2% annually against GDP growth of 4% to 5%.

That dynamic shifted sharply beginning with the FY2002 budget, and the trajectory has since been defined by widening structural deficits and ballooning debt.

Debt Begets Debt

As of September 2024 (the end of the last fiscal year), the Treasury’s debt outstanding was $35.5 trillion, and is expected to exceed the $36.1 trillion debt ceiling sometimes this summer (the Treasury expected the X-Date to fall sometime in August). This is double the $18.2 trillion outstanding at the end of fiscal-year 2015.

Problematically, but expectedly, interest rates have climbed alongside the ballooning debt and deficits. The Treasury’s debt is relatively front loaded (about one third of the total debt is due in under 1 year and two-thirds in under 5 years) therefore the increase in prevailing market rates has been passed through to the actual cost of debt fast.

The net result is that in 2025 the Treasury is expected to pay $1.22 trillion in interest expenses (~4.0% of GDP), triple the $400 billion paid in 2015 (~1.2% of GDP). This is proportionally consistent with the 100% jump in outstanding debt, and the rise in the average cost of debt from 2.35% in 2015 to 3.25% in 2024.

Policy Choices Aren't Helping: Tariffs and the Budget

So far so bleak, but let’s add the damage from proposed policy changes. Notably, the US needs foreign capital to finance its fiscal budget and, so far, international investors have agreed to do so with gusto over the past decade. At the close of 2024, the US Net International Investment Position (NIIP) stood at a $26.2 trillion liability compared to about $8 trillion in 2015 (which means foreigners invest in the US more than American invest abroad). The NIIP includes about $10 trillion invested in Treasury and Agency debt – somewhere between 25% and 35% all outstanding Federal and Agency debt.

Source: Bureau of Economic Analysis, US Department of Commerce

The problem, as we see it, is that the attempt to reduce trade flows will likely lead to lower supply of capital to fund the US deficit, while the increasing pace in deficit accumulation resulting from the OBBBA adds to America’s demand for capital to fund the Treasury. Which, naturally, is likely to lead to higher interest rates throughout the economy.

By attacking imports via higher tariffs, the Administration is indirectly eroding demand for Treasury and Agency paper. Usually, exporting nations re-direct inflows of trade-surplus dollars by building foreign currency reserves. One of the primary reasons is to avoid re-valuation of their local currencies, which could make their domestic industries less competitive.

To follow the flow, lets track an example of the money trail when a Chinese exporter sells good to an American importer:

1. The exporter puts goods on a ship, and the goods are picked up by the American importer;
2. the American buyer sends dollars to the Chinese exporter to pay for the goods;
3. the Chinese exporter sells the US$s to the People’s Bank of China (PBoC), receiving RMBs
4. the Chinese exporter injects RMBs into the Chinese economy by paying salaries, taxes, services, etc.
5. The PBoC allocates the newly acquired US$s to its foreign reserves
6. The PBoC’s agency managing reserves buys Treasury and Agency debt.

This cycle allows the PBoC to create a separation between the domestic economy and the flow of US$s, thus giving the Bank great capacity to manage the exchange rate between the RMB and US dollar.

And here lies the problem: the US administration stipulates that by manipulating the currency, the PBoC unfairly makes US manufacturers non-competitive, which is a reasonable argument. But it sidesteps that the alleged currency manipulation does a heavy lift in maintaining interest rates low for the American economy.

In addition, the OBBBA supercharges the deficit. As reflected in Moody’s report that downgraded the US sovereign rating to Aa1 from Aaa, the bill discussed in Congress (approved in the House, but likely to be modified in the Senate) pushed the already-worrisome deficit in the wrong direction. Moody’s anticipates that the OBBBA would increase the federal deficit by $4,000 trillion over the next decade, excluding the accompanying interest expense.

Perhaps importantly, Moody’s highlights that the Federal spending is becoming less flexible as it’s driven by entitlements and interest expenses. For example, it notes interest expenses are forecasted to reach 30% of the Federal budget by 2035, compared to 18% in 2024 and 9% in 2021, with all mandatory spending reaching 78% of total spending by 2035 compared to 73% in 2024. Consequently, correcting course on the deficit becomes increasingly more challenging with time.

Section 899: A Trojan Horse in the OBBBA

Section 899—"Enforcement of Remedies Against Unfair Foreign Taxes"—allows the Administration to impose punitive taxes on investors from countries deemed to tax U.S. firms unfairly.

The language is vague, with few guardrails. It permits additional taxes of up to 20% on persons or entities linked to these jurisdictions. This could significantly deter foreign investment in U.S. assets. The official text is available here.

We anticipate that Section 899 will be removed or substantially revised during Senate deliberations, given its potential to undercut Treasury demand.

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