DANCING ON THE EDGE: MARKET OPTIMISM VS. SOVEREIGN RISK

Habitual readers of this blog should be well familiar with our concerns about the state of the U.S. government’s finances. While never known for their fiscal restraint, politicians in the post-COVID era seem increasingly reliant on running massive fiscal deficits, regardless of party affiliation. These deficits, while likely necessary during the depths of the COVID economic crisis, make little sense as the economy has delivered steady resilient growth for several years now. This spending, coupled with the interest rates associated with a stubborn inflation environment, has significantly increased the cost of servicing the national debt, creating a negative feedback loop.

President Trump, and his Treasury Secretary, Scott Bessent, initially touted an economic plan centered around a “3-3-3” concept. The goals of the agenda were to have a federal deficit of 3% (down from 6.5%), GDP growth of 3% (up from 2%), and an increase of domestic oil production of 3 million barrels per day (an increase of nearly 25% from current levels). While this, combined with the touted goals of the DOGE initiative (Elon Musk’s program to cut government waste), sounded great in theory, it appears as though the administration has all but abandoned any hope of cutting spending. As a result, the President’s proposed budget is currently working its way through Congress and does little to ease concerns over the government’s fiscal position.

Our perspective is that the government plans to grow its way out of its debt problem. The budget bill is highly stimulative and will likely increase nominal growth. This dynamic, coupled with the ongoing uncertainty over tariff policy, should keep inflation running higher than what the Federal Reserve would prefer. All the talk of growth with the added kicker of lower taxes, could keep investors distracted as the costs of all these policies continue to increase.

Last weekend, Moody’s finally relented and downgraded the United States sovereign credit rating from Aaa to Aa1. While this certainly generated a fair share of headlines on a Friday evening, the reality is that their action has little practical effect in the market as investors have largely treated the U.S. government as a double-A credit for years. Also, the Treasury markets remain the most liquid in the world. Standard & Poor’s beat Moody’s to the punch by fourteen years, and even Fitch took the same action in 2023. So, while Moody’s actions won’t result in any margin calls or panicked selling, it does serve as another alarm bell about the government’s fiscal trajectory.

We think that investor sentiment will stay bullish, driven by the adage, “As long as the music is playing, you’ve got to get up and dance.” However, our positioning remains cautious. Dancing too close to a precipice increases the odds and consequences of a misstep. We continue to value preservation of capital as uncertainty increases.