by Joe Herrle, CFA
Vice President, Alternative Assets
The 2024 U.S. presidential election of Donald Trump has sparked optimism in the financial markets and corporate sentiment. While some of this enthusiasm may be attributed to the end of a tumultuous election, the positive market reactions in the immediate aftermath—including rising stock prices, declining bond yields and a strengthening dollar—suggest that domestic and international investors are responding favorably to Trump's proposed policies.
President-elect Trump's economic agenda for his second term is similar to his first’s, with some notable additions. Key new proposals include eliminating taxes on service tips and establishing a safe harbor for cryptocurrencies. However, looking at the high level of news coverage, it seems that markets are most excited about the establishment of the Department of Government Efficiency (DOGE), an advisory body aiming to streamline federal spending and implement fiscal reforms. This focus on government efficiency appears to be overshadowing concerns about potential tariffs, with investors showing greater enthusiasm for the prospects of fiscal reform than apprehension about trade barriers.
Recent inflationary pressures have thrust government spending into the spotlight, making DOGE a focal point for investors and analysts alike. This newfound interest in fiscal reform reflects growing concerns about the sustainability of current spending levels and their impact on the economy.
The buzz is also undoubtedly driven by the fact that Trump has selected two high-profile business leaders, Elon Musk and Vivek Ramaswamy, to lead the organization. Under their supervision, the DOGE aims to revolutionize federal operations with three primary objectives: 1) cut regulations to remove some unnecessary burdens on business; 2) shrink bureaucracy by reducing federal employment; and 3) cut spending by targeting wasteful expenditures, renegotiating contracts with vendors and increasing anti-fraud measures. The overarching goal is to streamline government operations, potentially saving up to $2 trillion in federal spending. Trump has set an ambitious timeline for DOGE, targeting completion by July 4, 2026 – the 250th anniversary of the Declaration of Independence.
The reason for the positive reception of the DOGE's mission becomes apparent when examining the current state of U.S. finances. The federal budget deficit, the amount the government spent in excess of tax receipts it received, will reach $1.8 trillion in 2024, marking the third-largest deficit recorded in nominal terms. Government spending as a percentage of GDP has grown from 20.6% pre-COVID to 24.2% in 2024. Left as-is, the Congressional Budget Office estimates this percentage to grow over the next ten years.
Source: Congressional Budget Office
A closer look at the $6.8 trillion of total annual government expenditures reveals the challenge ahead for the DOGE. Mandatory government spending, such as Social Security and Medicare, make up 63% of total outlays. The $882 billion of interest payments on the U.S. debt, which would also be considered mandatory, makes up 13% of spending. That leaves 24% in discretionary spending, or $1.6 trillion, that the DOGE could target. However, over $874 billion of that is defense spending, which is generally politically unpopular to cut.
The growing disparity between government spending and tax receipts has far-reaching implications for the economy and financial markets. One potential consequence is the emergence of "bond vigilantes" – investors who sell government bonds in response to policies they view as inflationary or fiscally irresponsible. We saw this in the mid-90s in response to growing deficits, when the 10-year U.S. Treasury yield increased dramatically from 5.2% to 8.0% in only a year. This resulted in government action that sustained decreased government spending as a percentage of GDP. Higher bond yields can cascade, increasing borrowing costs for corporations, consumers and the government. These factors could erode investor confidence and impact long-term economic growth if left unchecked.
While the goal to reduce the ever-expanding deficit seems intractable, the U.S. has experienced and overcome this problem before. Opportunities exist to resolve the issue: 1) tax receipts need to increase by growing incomes and corporate profits or increasing tax rates; 2) spending needs to decrease; or 3) both need to occur.
The U.S. has repeatedly proven that it is the world’s engine for growth, innovation and opportunity. For this reason, the growing fiscal deficit has yet to have negative consequences for our markets and economy. Although the budget shortfall can’t grow ad infinitum without repercussion, we are likely a fair distance from calamity. The recent attention paid to the problem gives hope that it will be addressed soon.
Takeaways for the Week:
The S&P 500 reached a new record high on Wednesday, the fifty-seventh time this year. Year-to-date, the index has returned 28.5%
The in-line consumer price index inflation reading of 2.7% year-over-year cleared one of the last remaining risks to easing by the Fed in December increasing the likelihood of a quarter-point rate cut this month
The November producer price index released Thursday morning was hotter than expected, rising 0.4% from the previous month. Economists had been expecting an increase of 0.2%, putting the chances of the Fed holding rates steady in January in focus, as several officials have voiced a cautious stance on policy