Over the past three years, the Federal Reserve has steadily raised short-term interest rates. Meanwhile, the M2 money supply — a key measure once championed by Milton Friedman — has been shrinking, bottoming out in late 2023.
Logically, tighter monetary policy should have slowed economic growth or even triggered a recession by now. Yet, it didn’t — at least not right away. So, what happened?
Short-Term Sugar Rush: Government Spending
One major reason the economy stayed afloat was an extraordinary level of government deficit spending. While we don’t view this kind of spending as healthy for long-term growth, it can give the economy a temporary boost.
For context: the federal deficit exceeded 6% of GDP in both fiscal years 2023 and 2024. That’s larger than anything seen in the 1980s — even during peak Cold War military funding and double-digit unemployment under President Reagan.
By comparison, recent years had no such external pressure. Unemployment was below 4%, and we weren’t in a major conflict. Yet the government continued spending at historic levels. That fiscal stimulus helped soften the blow from tighter monetary policy — but now, that cushion is being removed.
A Sudden Policy Shift: Tariffs and Taxation
We’re now entering a new phase. Fiscal support is fading, and the Trump Administration has pivoted to a dual strategy: cutting spending and raising tariffs.
According to the Tax Foundation, the cumulative impact of the latest tariff package could raise federal revenue by 0.85% of GDP — making it the largest peacetime tax increase since 1982. This surpasses the tax hikes under George H.W. Bush, Bill Clinton, or even the Obama administration.
To be clear, that figure is a static estimate and doesn’t account for changes in behavior, such as companies reshoring operations or consumers switching to domestic goods. Even so, these tariffs introduce significant short-term economic friction.
A Tough Environment for Growth — and Business Confidence
Unless Congress deepens the 2017 tax cuts rather than just extending them, many Americans could face a higher overall tax burden in 2026 than in 2024.
Meanwhile, tariffs could raise consumer prices and hurt business sentiment. Companies considering bringing operations back to the U.S. now face uncertainty — why invest in a new facility if the policy could reverse in two years?
All of this is unfolding while early estimates suggest U.S. real GDP was flat or negative in Q1 2025 (we’ll know more on April 30). With higher costs, growing uncertainty, and shrinking fiscal support, the economy is vulnerable — and recession risks are rising.
What This Means for Stocks
The recent market pullback was driven largely by these tariff announcements — but make no mistake: valuations were stretched even before that. If tariffs hadn’t triggered a drop in stock prices, something else likely would have.
That’s why, while many in the industry were forecasting continued gains, we went on record late last year projecting a 5,200 target for the S&P 500 in 2025 — a number that looked contrarian then, but more grounded now.
As of today, based on current earnings outlooks, the S&P 500 appears fairly valued — a meaningful shift from the overvalued levels of recent years.
Final Thoughts
We remain hopeful that current tariffs will ultimately serve as leverage for opening foreign markets to U.S. products. But until that happens, we’re entering a more fragile economic environment — one shaped by higher costs, tighter policy, and growing uncertainty.
Stay tuned. The next few months could be critical.