We were certainly caught off guard by the violence of the S&P’s recovery this week. Our model was stopped out of its “risk-off” position in the S&P well before Friday’s close, which brought the week’s rally to 4.6%.
Gold, the Euro, and the yen, which had been safe havens against the tariff wars, saw their appreciation abruptly halt, coincident with the rally in the stock markets.
To review quickly the triggers for the reversals,
President Trump indicated an openness to negotiating with China and reducing the 145% tariffs to around 60%.
Exemptions for electronic goods remain in place, and some flexibility is being considered for existing 25% auto tariffs.
Treasury Secretary Bessent has organized trade negotiations with the US’s major trade partners and discussions with India, Japan, and Korea, according to Bessent, are showing progress.
Trump’s popularity is suffering as a result of tariff uncertainty, making him more flexible.
Trump reduced pressure on Fed Chairman Jay Powell and told reporters he never had any intention of firing him.
S&P 500 company earnings are coming in better than expected (feared)
Fed Governors Waller and Hammack gave speeches hinting at a June rate cut, despite Jay Powell’s previous claims that vigilance against inflation remains the Central Bank’s priority.
To date, the 2025 market “narrative” has been tariffs, tariffs, tariffs. As time goes by, markets incorporate the current narrative into prices and begin to search for a new narrative.
My candidate for the new narrative:
The realization that the fiscal deficit isn’t going away may trigger a second wave of flight from US assets - stocks, bonds, and the currency itself.
Let’s outline the plot:
House Speaker Mike Johnson has successfully unified budget hawks in the Freedom Caucus with more moderate members and has worked with the Senate Majority Leader John Thune to produce a budget resolution that is $700 billion away from the House’s budget resolution, an amount that can be “reconciled” during the upcoming reconciliation process.
The negotiations will begin this week, and, needing a win, the Republicans will sprint throughout the month of May to reach the final version of the legislation.
They will have great debates to reach difficult decisions.
The budget resolutions cover spending over a ten-year period. For simplification, let’s look at the deficit increasers and deficit decreasers for the first year, making the (dubious) assumption that spending cuts and revenue increases are linearly distributed.
Deficit Increasers:
Extension of Trump’s 2017 Tax Cuts (TCJA)
-$450 billion
Cost of Trump campaign promises (No tax on tips/social security/others)
-$45 billion
Subsidy for farmers hurt by tariffs
-$70 billion
Lower tax receipts as a result of the economic slowdown induced by tariffs
-$70 billion
Higher Defense and Border Security Allocations
-$35 billion
Unemployment Benefits increase resulting from the tariff-induced economic slowdown
-$50 billion.
Total deficit increasers: -$720 billion.
Deficit decreasers:
Revenue from tariffs
+$400 billion
Spending cuts from Medicaid, food stamps, agency cutbacks, and reductions in Biden-era programs like the Inflation Reduction Act, and federal layoffs.
+$150 billion
Total deficit decreasers: +$ 650 billion
That works out to a net deficit increase of $70 billion.
Before the reconciliation process, the Congressional Budget Office projected the 2026 deficit at 5.50% of GDP. The reality is that the deficit will come in higher, around 5.75% of GDP.
That is lower than the FY 2024 deficit of 6.4%, but a long, long way from Secretary Bessent’s desired 3% deficit. Bessent will require a boom in the economy for revenues to rise sufficiently to arrive at that utopian fiscal destination.
The 5.75% deficit is also likely to increase over time. Here is why:
Tariff revenue is probably front-loaded. High tariffs will reduce imports or redirect them to countries with lower tariff rates. Revenue from tariffs, therefore, decreases every year.
Conversely, spending cuts from Medicaid and other social programs are likely to be backloaded, as implementation will take time. Savings from DOGE will help only slightly, but Musk has come far short of his original pie-in-the-sky claims of saving $2 trillion. Best estimates are now in the neighborhood of $50 billion total DOGE savings, which I have incorporated into the spending cuts.
That means a big part of the savings must come from lower spending on social programs.
This is the problem: About thirty-five percent of the US population is on either Medicaid or SNAP (Food Stamps). That percentage comes close to fifty in some congressional districts, including Republican ones. It would be political suicide to touch those benefits. Trump himself has vowed not to cut them, and resistance to possible cuts by Republicans whose states and districts would be affected will be fierce.
The technical debate in Congress will be whether efficiency savings from reducing “waste, abuse, and fraud” can reach this ambitious spending cut objective without cutting actual benefits. Congress might punt and reduce transfers to the states, forcing them to make the tough choice between raising taxes or reducing benefits to Medicaid/food stamps recipients.
Unless the reconciliation bill convincingly lowers spending, the bond market will react negatively, and rates will move higher. A rebellion by the bond vigilantes may spill over and contaminate equity markets.
The macro message remains the same. Investors should stay wary that Trump’s departure from the existing geopolitical and economic order will bring about an economic slowdown. Major Wall Street firms are predicting a forty to fifty percent chance of a recession this year. Markets will adapt to the regime change and Trump’s big, beautiful tariff world, but the overall storyline hasn’t changed.
Long-term investors would be wise to continue to diversify out of US equities into large-cap lower volatility industrials, short-term Treasuries, foreign stocks, and commodities like gold, platinum, and even oil. There are ETFs to express these views.
One quick footnote to our story is the fascinating but far-fetched creation of a US Sovereign Wealth Fund. Its effect would be for Bessent to convince investors to focus on the asset side of the US balance sheet, thereby offering “collateral” to secure the creditworthiness of US Treasuries. That, though, is the subject for another post. Perhaps it might develop into the third chapter of this year’s narrative.
For the very near term, stocks will be supported by the possibility of positive headlines from Trump and Bessent’s tariff negotiations. Any “deal” will be just a “Memorandum of Understanding,” light on details, but enough to keep he bulls buying. If Friday’s employment report shows weakness in the job market, the bulls will celebrate a higher chance of Fed rate cuts this summer.
Key this week will be the important earnings releases from tech giants Facebook and Microsoft, along with smaller companies but key economic bellweathers - Hilton, Pfizer, Starbucks, Caterpillar, Eli Lily, and McDonald’s, to name just a few of the dozens of companies in the S&P which will guide how they expect to weather the tariff storm.
Have a good one, and please, leave a like if you can.
The Monitor is neutral for this week.
Disclaimer: The content of this post reflects only the views of the author and not necessarily those of Armor Capital.