A One-Step Back, Two-Steps Forward Policy Approach

By Adam Thurgood on March 18, 2025

To put it mildly, the first few months of 2025 have been a whirlwind.  From politics to the response in financial markets, this year has had plenty to keep us on our toes.  With the Trump administration moving fast and breaking things (some by design), have signs of a new trend in global financial markets begun to emerge?  In stark contrast to the past couple of years, international developed markets (think Japan, Germany, the UK, etc.) have outperformed the S&P 500 by a whopping 14% year-to-date.  Even emerging markets are outperforming the S&P 500 by a wide margin.  So why the angst in U.S. markets?

As we highlighted in our January piece, “Sentiment, Expectations, & Risks”, U.S. growth expectations were sky high.  When paired with lofty valuations, the risks to U.S. equities (specifically the S&P 500) were elevated.  All that was missing to put those risks into play was a growth scare, which now seems to be playing out.  The chart below shows the economic surprise index of the major economic players of the world.  The indices measure how economic data compares to expectations.  As you can see, the U.S. has moved firmly into negative territory (disappointing vs expectations), while the other major players have surprised to the upside.

Our leading economic model supports the view that the U.S. economy is weakening.  We measure the four main contributors to economic activity (employment, production, consumption, and income), through a series of leading economic indicators.  What you’ll notice in the graphic below is that recessions tend to occur when all four are weak.  Today, leading measures of consumption and income are quite weak while production and employment have moved slightly below zero.  While we aren’t at levels that suggest a recession is imminent, the probability of slower growth in the U.S., and therefore continued disappointment versus lofty expectations, is high.

One would think under such circumstances that the Trump administration would be focused on spurring economic activity.  However, that is not what we’re seeing in action nor is it what the Trump administration is messaging.  The Department of Government Efficiency (DOGE), led by Elon Musk, is actively freezing and cutting federal spending, which is growth negative.  President Trump’s flip flopping on tariffs is also causing uncertainty in the business community.  The massive post-election spike in small business optimism is fading, while U.S. stock markets have retraced. 

For a president that was fixated on the performance of U.S. stocks in his first term, it’s understandable if your natural reaction is to scratch your head at the current state of affairs.  However, building a mosaic from all the bits and pieces of information we’ve analyzed leads us to believe that the Trump administration is deliberately taking a one-step back, two-steps forward approach. 

Before diving in further, I believe I need to acknowledge where I stand on the political spectrum.  I am a lifelong independent that has more or less been displeased with the bulk of our country’s leaders since entering adulthood in the 1990’s.  I am no fan of Donald Trump and his belligerent approach to politics.  That being said, I believe Trump’s economic team is perhaps the best we’ve seen in my lifetime. Treasury Secretary Scott Bessent and Stephen Miran, Chair of the Council of Economic Advisers, possess serious financial minds and understand markets at a deep level.  The teams behind them are also incredibly bright.  Together, they are driving the policy framework that we are seeing today. 

Secretary Bessent has three main priorities, which are referred to as 3-3-3.  He wants to build an economy that, over the long run, produces 3% real GDP growth, with no more than 3% budget deficits and an increase of 3 million barrels per day of energy equivalent oil production.  Accomplishing this will no doubt be difficult, but if successful, would unleash an economic boom.  However, in the short run, their top priority is to drive interest rates and inflation expectations lower, and this is where the one step back component of their policy approach enters the equation.

U.S. federal debt has exploded, especially over the past five years.  Right before COVID hit, the U.S. had accumulated roughly $23 trillion in debt (over nearly 250 years).  Since COVID, we’ve added another $13 trillion, bringing the total federal debt to over $36 trillion.  The average interest expense on this debt is 3.3%, which means over $1.2 trillion dollars in interest expense is due annually, about the same amount of money we spend each year on defense.  According to the Joint Economic Committee of the U.S. Congress, roughly 33% of this debt will mature over the next twelve months (~$9.5 trillion).  On top of that, another $2 trillion in new debt is expected to be issued.    With current interest rates above 3.3%, this new issuance will further weigh the U.S. down under the heavy burden of elevated interest expense.

If that isn’t troubling enough, there is a private sector debt maturity wall quickly approaching.  As interest rates collapsed during COVID, many consumers refinanced their homes at attractive yields that are locked in for another 10-25 years.  Businesses also jumped on the financing opportunity and either refinanced or issued new debt in 2020 and 2021.  Unlike home mortgage debt, corporate debt tends to have shorter maturities, typically in the 5–7-year range.  As a result, a lot of low interest debt is set to re-price much higher.  According to Newmark, almost $1 trillion in commercial real estate loans are set to mature in 2025.  The only near-term remedy for this conundrum is lower interest rates that allow for a non-punitive refinancing cycle to occur.

Interest rates are a function of growth and inflation expectations, and understanding the backdrop of each component helps bring clarity to the administration’s policy approach.  On the inflation front, expectations remain elevated.  From 2010-2020, one-year inflation expectations, as measured by inflation breakeven rates, averaged about 1% while rarely going above 2%.  Since 2020, the average one-year inflation expectation has averaged 2.8% while rarely falling below the prior decade’s average.  Today, one-year inflation expectations are nearly 4%.  This is a regime change and one that puts upward pressure on interest rates.

On the growth front, one important driver has been the wealth effect.  Higher asset prices tend to make people feel better about their finances, leading to more spending and economic activity.  Due to a policy mix focused on the wealth effect, the U.S. economy has become hyper-financialized, meaning asset prices tend to drive economic activity instead of the other way around.  Sure, plenty of other factors go into the growth equation but asset prices are now playing a larger role than perhaps they should, especially with so much speculative behavior in financial markets.

Asset prices near all-time highs with elevated inflation expectations was not a recipe for lower rates.  As a result, a deliberate policy approach was crafted to slow economic activity and ease inflationary pressures to push rates lower.  In other words, taking a step back.  Bessent has all but confirmed this is deliberate policy, as he’s been quoted as saying “there will be a detox period” and “corrections are healthy.”  In a recent interview on NBC’s Meet the Press, Secretary Bessent said “I’m not worried about the markets.  Over the long term, if we put good tax policy in place, deregulation and energy security, the markets will do great.” 

Taking a one-step back, two-steps forward approach is a bold move that will have near-term consequences.  If the economy slows, people will lose their jobs.  Investors in U.S. assets, especially overvalued areas of the market, will feel the pain of lower prices.  Consumer sentiment will fall as well as Trump’s favorability ratings.  In the world of politics, it’s rare to see a willingness to take this risk.  However, the best time to take the risk is at the beginning of a term with plenty of time for the “two-steps forward” piece of the policy to play out before the next election. 

Determining whether this policy approach will be successful, or if they will have the intestinal fortitude to stick with it, is nearly impossible at this point.  Perhaps Secretary Bessent and his team’s financial market acumen and experience with volatility increases the odds they won’t cave as easily.  However, the problem with intentionally slowing an economy and removing animal spirits from markets is that it’s hard to control negative feedback loops, as well as second and third order effects.  Only time will tell.  In the interim, our job is to manage through it and having a globally diversified portfolio is paying off in spades so far this year.