Market review Q2 25: Ping-pong policy

Stocks rose over 10% through the quarter finishing at new all-time highs and the benchmark 60/40 balanced fund finished the quarter up over 7%. After "Liberation Day" tariffs liberated investors from a good chunk of their wealth early in the quarter, a pause on the tariffs restored it and the winning ways of stocks continued through quarter-end.

The rapid rebound presents investors with a number of questions and challenges though. Was the "Liberation Day" selloff just a blip or was it indicative of more challenges to come? Now that the budget bill has passed, what should investors expect? Will the Trump administration continue to run the economy "hot"?

Whirlwind

The most prominent phenomenon of the quarter was the continuation of a frenzied media environment. The news was loud, voluminous, often contradictory, and often perplexing. This would have been disorienting enough for investors, but it also coincided with the poor performance of several companies and industries deemed to be beneficiaries of Trump administration policies (e.g., oil and gas). Why didn't these ideas work?

The answer has been right in front of our noses: The Trump administration simply has not had the policy space to accomplish many of its campaign promises. The business of government is constrained economically by excessive debt and a large fiscal deficit, and politically by an electorate wholly unwilling to accept the need for sacrifice. This creates a situation conducive to overpromising and underdelivering.

This is why politics and the public policy that derives from it were described in the January Outlook piece as "key drivers last year" and were expected "to be so again in the new year". The main point is, when underlying economic conditions are not sufficient on their own to comfortably meet people's expectations, story-telling and narrative formation are cheap and easy tools to keep sentiment from spinning out of control.

This framework also applies more broadly to geopolitics. Other large economies face similar economic constraints and therefore are also experiencing similar political phenomena. In addition, large, powerful countries always have the additional option of imposing their will on others as a way to mitigate their own economic constraints. This is why the January Outlook piece also forecasted a geopolitical environment that involved "more conflict around the world".

The main point here is to recognize that governments, even those of large, powerful countries like the US, have less agency than many investors assume. They can't do just whatever they want. Every policy choice comes with consequences.

A different perspective

This reality suggests a different framework for evaluating the impact on the investment environment. Trying to guess specific policies per se is always a crapshoot; the odds are not good because there are so many possibilities. However, when policy constraints are severe, there is much less room for maneuver and therefore fewer realistic options to choose from.

The exercise can be likened to card counting. Even though you don't know what cards will come out or in what order, after a number of cards are dealt, you can start getting a sense of whether your odds are better than usual, worse than usual, or about the same.

Likewise, in the economic "card game", excessive debt significantly reduces an economy's capacity to grow. This was the seminal finding of Carmen Reinhart and Ken Rogoff and in their 2011 book, This Time is Different. They found the level of debt/GDP of 90% to be the threshold beyond which debt tended to impinge upon economic growth. With current debt held by the public/GDP at about 100%, the US is obviously clearly beyond that threshold.

Perhaps one of the clearest indications excessive debt is constraining public policy has come from the Treasury. When debt grew during the Biden administration, Secretary Yellen decided to alter the issuance schedule in favor of short-term debt for fear inadequate demand for bonds would push yields high enough to cripple the economy. With debt now also growing under the Trump administration, Secretary Bessent has taken a similar tack despite having harshly criticized Yellen at the time.

The implication is that excessive debt is constraining policy choices by weighing on longer-term yields. If debt was not a problem, there would be no need for shenanigans with issuance. These are not the types of decisions that are made from a position of strength. Nor are they decisions without consequences.

The challenge for the Treasury is now becoming even more immediate with the passage of the budget bill because the debt ceiling is raised. As Treasury replenishes its general account and shifts annual issuance higher, the potential for supply to overwhelm demand and to drive yields higher is clear and present.

This quandary is exactly why we have heard mention of several unusual policy options lately. Such options include easing regulations (e.g., the Supplemental Leverage Ratio), continued disproportionate issuance of short-term bills, reducing or even eliminating issuance of 10-year bonds, and re-evaluation of the use of the Fed's balance sheet.

The main point here is that none of these ideas would be seriously considered on their own merits because each comes with negative consequences. They are only in play because the consequences of higher bond yields would likely be even worse. This is just one example of how excessive debt constrains policy options.

General implications

As public policy constraints become increasingly severe, the tradeoffs become increasingly unattractive and imply heightened risk. This doesn’t mean the consequences will be immediate, but it does mean the path forward gets harder.

Beyond a certain threshold, the only remaining options all have serious shortcomings. The tradeoffs are between bad and perhaps slightly less bad. At this point, there is no easy, relatively painless way out and the odds of a benign outcome are vanishingly small.

This is the stage when policymakers are forced to reach into their bag of tricks in order to forestall the consequences that threaten their hold on power. One of the tricks is to buy time, to kick the can down the road. Another is to deploy narratives to deceive and manipulate public opinion. The presence of loud and aggressive politics and policy tradeoffs that sacrifice long-term benefits for short-term continuity are strong indications that policy constraints are biting.

The best guide in such an environment is to evaluate policy tradeoffs for indications of how much room is left for maneuver. The less room there is, the more imminent a catalyzing event.

Portfolio implications

To be sure, the Trump administration inherited a government beset by a multitude of financial challenges that promised to constrain economic prospects from the start. Now, with a nearly six-month track record to evaluate, investors can start to make some judgments about policy decisions, tradeoffs, and what they mean for investors.

For starters, the broad pattern of Trump administration policies to date reflects little desire to fix economic problems. The massive expansion of debt in the new budget bill, Treasury debt management practices that favor short-term debt, the pattern of disinvestment in health, science, and education, and a thuggish approach to international relations all more closely resemble a political project than an effort of responsible governance.

One of the indications Trump administration policies are failing to strengthen the US economy is the weakness of the US dollar. A weak dollar undermines consumer purchasing power and therefore dampens real investment returns. In addition, since US stocks and bonds comprise a majority of most portfolios, long-term investors should be especially diligent about managing this risk.

The persistent use of loud and aggressive politics by the Trump administration also has implications for investors. Some of the policy narratives portray economic conditions as better than they are. Others fantasize about an impossibly idyllic future. Still others criticize those with different political beliefs. Many of the statements are simply designed to deflect and avoid criticism.

If one takes just a step or two back in order to gain perspective, it’s easy to see that none of these applications of narrative are designed to solve problems. Rather, they are all designed to consolidate power. One of the ways in which this is accomplished is by instilling enough uncertainty and doubt so as to inhibit investors from making big changes to spending habits or investment decisions. The resultant “non-action” serves as an implicit endorsement that buys more time, but at the expense of a more severe reckoning in the future.

One last portfolio implication is that in a highly politicized investment landscape, with a highly capricious president, the proposition of short selling is especially challenging. Yes, excessive debt does constrain policy in important ways. That said, on few issues has Trump proven to be a reliable or consistent advocate. It is not at all unusual for him to make quick U-turns – and that puts a lot of bets at risk.

Conclusion

As public policy has become a progressively greater influence on the investment landscape, it is natural to look for clues as to which direction it is tilting. While investing on the basis of public policy wishes has been understandable, it has mainly failed because of the constraints that financial burdens impose on policy. Instead, a more fruitful approach is to identify the degree to which financial burdens constrain policy and then explore the types of tradeoffs that are forced.

Given the existing constraints on the Trump administration, there is virtually no chance of realizing strong economic growth without substantial public policy support. Further, with excessive debt and high deficits, there is only very limited room for policy support. Anything that is done will come with negative consequences down the line.

Under such conditions, one policy option is to run the economy “hot”. Though not especially intuitive, it is the course suggested by the massive spending increases in the newly passed budget bill. This will further consume limited national resources but will likely forestall a painful recession for some period of time. It runs the risk of running too hot and triggering inflation.

Another option is to run the economy “cold”. This involves paring back on policy support of markets and allowing growth to slow. Think back to late March when the Trump administration suggested a “detox” period was needed and then introduced a massive array of tariffs in early April. This runs the risk of initiating an uncontrollable selloff.

Finally, a third possible option is to run hot, then cold, then hot, then cold, etc. It can be thought of as “ping-pong” policy. This involves running the “hot” playbook until inflation and/or bond yields get too high and then switching to the “cold” playbook until bond yields recede and recession risk gets too high. Rinse and repeat.

This option has the benefit of preventing consumers, businesses and investors from gaining enough confidence in the economic trajectory to significantly alter spending or investment patterns. As a result, it also extends the useful life of each playbook on its own and buys more time.

What isn’t uncertain in any of this is that government debt at current levels severely constrains the space for public policy. The next time government will need to come to the rescue, whether for recession, war, a big bank bailout, or some other emergency, it will thrust government finances into crisis. When that happens, government will come for investors because there won’t be other viable options. Perhaps this knowledge will help some investors to seek shelter before it’s too late.

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