Things have been moving fast since the new administration has taken office. As we are concluding this Commentary, equity markets are down sharply as new tariffs have been put in place. Tariffs are clearly dominating the news cycle, and markets have responded negatively. But tariffs aren’t the only story. Much has been occurring over these past few months. There are both real changes and noise. As investors, we must focus on what is important as it pertains to our portfolios, not just for what is occurring now, but also to position portfolios to meet long-term objectives.
In this issue we will discuss government cost cutting and efficiency, trade, government debt, and other actions that might impact the economy and markets. We will attempt to tie it together and provide our assessment of what to expect and how that influences our investment stance.
A fundamental problem for the economy is the size and cost of government and the resultant debt burden. U.S. GDP in 2024 was approximately $29.7 trillion. Of that, government spending was about 11.7 trillion consisting of $6.8 trillion by the federal government and the balance by state and local governments. The federal budget deficit was about $2 trillion. This introduces inefficiencies, limits policy options, and creates system wide burdens.
Partially in response to these issues, the Trump administration is taking steps to reduce regulation and the size of the government. Reducing the size of government and shrinking the regulatory state will remove significant costs to the economy. Just as tariffs add costs, regulations and bloated government create bottlenecks, drain tax dollars, and add costs to doing business. The last administration vastly increased the cost to the economy of regulations, as the chart below shows. The $1.8 trillion increase in regulatory burden, which is the government’s own estimate as published in the Federal Register, far exceeds that of any previous administration. Most of this burden was added in 2024. We think these cost estimates are, as a matter of course, understated. To the extent regulatory burdens are reduced and those savings go back into the economy, the actions are a net plus to investors irrespective of the merit of the specific regulations. In our opinion, the potential economic impact of the government’s efforts has been somewhat overlooked.
Reducing the size of government will not be easy. As the next chart shows, discretionary spending only accounts for 28% of the federal spending. Of this, nearly half is defense spending. The other 72% consists of interest and mandatory spending – mostly Social Security, Medicare, and Medicaid.
The government’s interest burden can only come down to the extent that either interest rates fall and / or the level of debt relative to the size of the economy falls. This limits the government’s policy options. This is because policies that increase government debt will, in the absence of a decrease in interest rates, increase that burden. Additionally, to the extent policies are merely perceived to increase the magnitude of government deficits, there is a significant possibility that interest rates will go up. The burden then increases further.
While reducing the amount of discretionary spending and improving the efficiency of operations will be helpful, no real progress can be made without addressing the mandatory spending items. While these programs can be made more efficient without congressional involvement, major changes cannot be accomplished by the president alone. It is not clear to us that there is the political will to effect significant changes in mandatory spending items. Nonetheless, the more successful the government is in grappling with these issues, the more those savings will offset any costs to the economy associated with tariffs.
Turning to those tariffs, there are some positives. Forcing other countries to open up their markets to U.S. goods and services can accelerate growth and lower costs. This would be by far the best outcome for us as investors. We could end up with both free and fair trade. There may also be some merit in strengthening domestic sources and not having free trade when it comes to strategic industries such as defense and its suppliers. And finally, one of the goals of the tariffs is to stimulate domestic investments such as the building of local factories. The actual investments, should they occur, will accelerate U.S. growth while they are being made.
On the other hand, tariffs increase costs, decrease consumer selection, and decrease the overall volume of economic activity. In short, the economy becomes less efficient. While the cost of tariffs are felt immediately, the time it takes for the economy to adjust by procuring new inputs and building factories can often be measured in years. Alternatives, in the short-run, may not be available, and retaliatory actions by our trading partners can be detrimental as well. This partially explains the strong reactions by the markets. Finally, hoped for government revenues tend to be elusive. To the extent purchases shift to domestic sources, revenues to the government from tariffs disappear.
Not only do tariffs increase prices, but so too do labor shortages. Shifting production to the U.S. will only require more labor. If the administration is as serious as it seems to be with respect to illegal immigration, then the labor markets will only become tighter. The nation can increase legal immigration, but currently we don’t see any significant moves in this direction. The other solution is productivity improvements. While artificial intelligence, robotics, etc. can help here, the lead times for improvements that offset labor shortages are likely to be substantial.
Lastly, we will address tax policy. The president has floated several proposals. While they all seem attractive to us as tax payers, this is where government deficits and the amount of outstanding debt come into play. While we believe most of the tax cuts enacted in 2018 will be extended or made permanent, it will be difficult to enact other cuts. Revenues from tariffs may help, but as we explained previously, they tend to diminish over time.
Tying it all together, we see both inflationary forces – tariffs and labor shortages – and we see disinflationary pressures – deregulation and productivity gains. On net, we think inflation will be a persistent problem, but we don’t see 1970s type inflation befalling us. Economic growth will likely be erratic with both positive and negative quarters of GDP growth as the economy adjusts to new realities.
While tariffs are a negative, especially in the shorter run, it is very possible that the tariffs will be reduced at some point. It is not clear to us to what extent the president is utilizing tariffs as a tool to negotiate truly free trade, a way to wall off the U.S. economy, as an instrument to bend the world to U.S. geopolitical demands, or some combination. We’ve heard Mr. Trump likened to a master chess player as well as to being completely ignorant. While both are extremes, we believe the president’s actions can be better compared to those of a poker player. To that extent, he seeks to keep his opponents off guard and refuses to show his cards.
While this may work in the long run, it creates uncertainty – both in the markets and the real world. To that extent, stock prices are lower and businesses become reluctant to invest. These lengthen the time for the economy to adjust.
While we have been concerned about these issues, we believe at some point the economic growth will reaccelerate, and this will be good for our clients’ portfolios. Then why don’t we pull back on our equity positions at this point and wait? One risk is just being wrong. Afterall it is possible that the current correction shortly runs its course. A bigger risk, however, is that we are right but are unable to increase our equity exposure at the right point. Many will recall 2020 when the markets fell off in response to the Covid virus. There was a sharpselloff that began in late February. It lasted one month and for the year stocks were sharply up. If tariffs are suddenly reduced, as one example of an event that might occur, markets could suddenly accelerate upward. It may not even be the president’s desire. If political winds shift strongly against the president, or court challenges force his hand, we might see stocks quickly reverse course and head upward.
We also see various possibilities for interest rates. As the economy adjusts, we see the possibility of lower interest rates with slower growth. In the immediate aftermath of increased tariffs, this is what the markets are currently expecting. Additionally, we may see an accommodative Federal Reserve. Even if the Fed is accommodative, they only have control of very short interest rates. We also see the possibility of higher interest rates if inflation accelerates or if federal deficits keep rising. This clearly has not been priced into the markets.
We think the best course of action at this point is to keep equity portfolios diversified and bond maturities spread out. Stocks should be for long-term needs. If funds are needed in the short-term, cash and fixed income may be an important part of the portfolio. We recognize that the current turmoil is detrimental to portfolio returns. Nonetheless, we think the most appropriate strategy is to stay calm and stay invested.
Past performance does not guarantee future results. Pinnacle Capital Management is an SEC Registered Investment Advisor and proud member of the Pinnacle Family of Companies, an organization designed to provide a full range of financial solutions to individuals, businesses, and institutions. For more information on our member companies, visit Pinnacle-LLC.com. Opinions are our own and do not constitute financial advice. Talk to your financial professional for any advice specific to your situation.