For as long as we have been working in the financial industry, which comprises more decades than we care to let on, people have been worrying about debt and deficits. Throughout this time, though, investors the world over, institutional and individual alike, have been reliable buyers of US government debt. Deficit hawks, fretting over irresponsible Washington spending, turned out to be Cassandras endlessly predicting a financial apocalypse that never happened.

But the debt continued to grow, and so did the size of the deficit. In the 1980s the federal deficit was typically somewhere around one to two percent of GDP; today it is above six percent. In 1985, while we were all bopping out to “Wake Me Up Before You Go-Go” and knocking back Crystal Lite in our leg warmers, the total public debt was about 40 percent of GDP; today, that ratio is near a peacetime high of 120 percent. The conditions have changed, and those beaten-down deficit hawks may be on the cusp of having their told-you-so moment.

A Tale of R and g

In the world of finance, an upper cap R is the symbol for the rate of return, expressed as a yield on an investment, while g (lower cap) signifies the projected long-term growth rate. At the macroeconomic level of national output, these two terms come together in a relationship between the economic rate of growth and the cost of borrowing to obtain that growth, both adjusted for inflation. Long-term solvency is achieved by the rate of growth being higher than the rate of borrowing.

With that in mind, consider the chart below, showing the past three years of real year-on-year US GDP growth versus the yield on 10-year inflation-protected US Treasuries (TIPS).

As the chart shows, the relationship between borrowing costs and growth is extremely close, with inflation-adjusted Treasury yields slightly outpacing real growth rates. In a couple weeks we will get the first reading for third quarter GDP growth, and the current consensus among economists is for growth to be right around the same two percent (year-on-year) level as it was for the second quarter. We show this in the chart with the crimson dotted line.

The Specter of Stagflation

Why is this important? Well, it’s the same as any situation involving debt and income. If you take out a personal loan, your own household finances will be fine as long as (a) you don’t borrow an ungodly sum, and (b) your household income grows at a faster rate than what you pay in interest and principal on the loan every month. If that equation changes – if you lose your job, or your salary flatlines, or you have a variable rate of interest on the loan that suddenly shoots up – then your financial situation is precarious.

Which brings us to the question on everyone’s mind in 2025: what is going to happen to the US economy? If interest rates subside a bit and growth picks up, then the debt situation becomes more manageable. Unfortunately, that does not appear to be the likeliest scenario. The bill that made its way through Congress last week stands to add a substantial amount of debt to the national balance sheet, with an estimated $3.3 trillion addition to the deficit over the next ten years.

Meanwhile, even after backing away from the most outlandish tariffs announced back in April, the average global tariff on goods coming into the US stands at 15 percent, the highest since the Smoot-Hawley tariff era of the 1930s (never a good decade to which to be making economic comparisons). The potential for structurally higher inflation and lower growth – stagflation, in other words – is real, and the probability of this scenario coming to pass is growing by the day.

There are policy prescriptions that could make the stagflation outcome less likely, but we see no evidence of them emerging from the current batch of individuals making economic policy. As for investment portfolios, there is no perfect strategy against stagflation. But it raises the importance, in our view, of a careful and deliberate diversification, across geographies and asset classes for both equities and fixed income. The chips will fall in different ways in different places in the coming months and years. Disciplined asset allocation is about to get a lot trickier, and a lot more important.

The third quarter of 2025 is underway. So far, at least, it has seamlessly picked up the baton from Q2: quiet headline data that fails to make an impact on the Alfred E. Neuman (what, me worry?) market that we talked about in our commentary last week. Today, that headline data point is the monthly jobs report from the Bureau of Labor Statistics. Now, we might have expected this report to land on our desks with all the angst of an awkward middle schooler. Earlier this week a different jobs report, the ADP Employment Survey, showed a net loss in hiring for June, with payrolls shrinking by 33,000 souls. Would the BLS report, where economists expected to see payroll gains of 117,500 and a slight uptick in unemployment to 4.3 percent, also deliver a surprise to the downside?

Nope. The Bureau reported a 147,000 increase in nonfarm payrolls and a small decrease in the unemployment rate to 4.1 percent. Given where we are in the economic cycle, that’s about as tidy a labor market snapshot as one could hope for.

All Roads Lead to Healthcare

Around a third of those nonfarm payroll gains are attributable to one single industry: healthcare. This is consistent with the trend thus far this year; in fact, healthcare is the nation’s top employer, growing from nine percent of the total workforce in 2000 to around 13 percent today. Along with the increase in bodies employed as healthcare workers, their salaries have been rising as well. On average since 1980, wages in healthcare have grown at nearly twice the rate of pay in the rest of the economy. And, in what will come as a surprise to absolutely nobody, American households now spend more annually on health-related expenses than they do on groceries or housing.

So it would not be inaccurate to say that as healthcare goes, so goes the US economy. Which brings us to the other bit of news this week: the tax cut and spending bill that is working its way through the House and has a very high likelihood of arriving on the president’s desk for signing roughly sometime not too long after this commentary appears in your inbox. There is plenty to be concerned about in this bill (to put it mildly), but let’s focus on the bits that pertain to healthcare.

Not Going to Age Well

The American population, like those in most other countries, is ageing. As the country gets older, access to affordable healthcare becomes more important. The bill that is about to become law, however, is expected to make steep cuts to Medicaid and other healthcare subsidies to the tune of around one trillion dollars over the next decade, resulting in somewhere between 12 to 17 million Americans losing their health insurance. Medicaid, which primarily serves lower-income households, makes up around one sixth of total healthcare spending. The spending cuts are likely to weigh heavily on the operations of clinics, hospitals and other providers of services to low-income communities. We expect this will show up, sooner or later, in the jobs numbers that healthcare’s fortunes have kept buoyant for so long. Unfortunately, it is also likely to show up in the statistics showing a country getting sicker as it ages.

The US economy has a history of being remarkably flexible in adapting to changing circumstances. When manufacturing jobs left the country in the 1990s and early 2000s, the growing healthcare industry was able to cushion the blow for anyone willing to trade in production-line skills for training in nursing, lab technician work and the like. We may be approaching another one of those junctures where new doors will have to open as others close. What lies on the other side of those doors, though, remains to be seen.

If you had to put a human face to the performance of financial markets so far in 2025, to whom would that face bear a likeness? Ten weeks ago, a likely answer might have been Donald Trump, whose authorship of the most radical tariff ideas for the US since the Depression-era Smoot-Hawley Act was sending the stock and bond markets into alternating paroxysms of fear and relief. Six weeks ago the answer might have been Scott Bessent, the Treasury Secretary, whose measured comments and apparent ability to navigate a steady course through the crazy tweets and policy reversals provided a balm to soothe Wall Street’s frayed nerves.

What, Me Worry?

Our choice for the Face of 2025, though, is neither Bessent nor Trump, nor Jay Powell nor anyone else in the business of financial policymaking. It is Alfred E. Neuman, the iconic avatar of Mad Magazine, a media publication so old that it evokes fond childhood memories even for those of us now in our sixties. The self-satisfied, gap-toothed grin of Mr. Neuman, beaming out from the cover as we eagerly tore into a new issue replete with the Spy versus Spy feature and inane parodies of whatever the hit movie of the day was, bore the message “What, me worry?”

And that seems to be the Zeitgeist of markets in 2025. Everything matters in the world, from old wars (Ukraine) to new wars (Iran), from gutting scientific research grants to flirting with ever-higher debt and deficits, all while pushing the pedal to the metal in our haste to reach the holy grail of artificial general intelligence (AGI) without having any idea what awaits us when (if) we reach that particular Shangri-la. But here in the land of the Dow Jones Industrial Average and the Barclays US Aggregate Bond Index, it’s summertime and the living is easy. Stocks have now recovered substantially all they lost in the wake of the tariff announcements – the S&P 500 is trading right around its last record high, set on February 19, as we write this, while the yield on the 10-year Treasury note is ambling along around 0.25 percent below where it was when the year began.

Too Big to Fail?

Are we surprised at the extent to which calm has returned to markets, given the extreme tempests of April? A bit, yes, but remember that one of our top-level theses in the annual outlook we published back in January was our expectation that markets would act as a guardrail of sorts against the most outlandish ideas of the new administration finding their way into law. Once investors figured out that this dynamic hadn’t changed from what they remembered of the first Trump administration, it was all well and back to the brandy. The assumption baked into this assessment is that markets are too big to fail and no administration – especially one that considers ultra-wealthy finance types as a core constituent of its political base – is going to let them fail.

And not just with regard to stocks and bonds. Just this morning we had something of a guardrail-imposed walk-back in reaction to events in the currency market. The US dollar dropped like a stone after a media report made the rounds suggesting that the administration might formally nominate a new Fed chair before the end of this summer, which conjured up the notion of a “shadow Fed” skulking behind Jay Powell for months before his term ends in May next year, casting aspersions on policy decisions not in line with the administration’s preference for steep and immediate interest rate cuts, and tarnishing the Fed’s credibility. The White House promptly put out a statement that no such decision was “imminent,” which was enough to claw back some of the losses the greenback had suffered against the euro and other key currencies.

So the first half of the year will end with not much more than a whimper. Will our luck hold in the second half? Maybe – but while the summer breezes might be gentle now, we are heading into that time of the year when the “low-vol, high-vol” dynamic can be at play. In other words, low trading volume with the resulting potential for high volatility. As we noted in our commentary last week, the coming weeks could bring some unwelcome macro surprises in the form of higher inflation, as the tariff effect finally shows up further down the production value chain, and lower growth as dampened consumer sentiment turns into lower spending. Events in the real world are not going to stop pushing and shoving at markets, and there is always a non-zero probability that one thing or another will penetrate that preternatural calm we have been seeing of late.

Relative to how these things can sometimes go, the Federal Open Market Committee’s meeting this week was a bit of a nonevent for markets. The Fed was widely expected to keep interest rates where they have been since last September, with a Fed funds rate upper bound of 4.5 percent, and that is precisely what happened. The FOMC meeting concluded and the trading day ended with not much more than a shrug from the stock and bond markets. But below the headline takeaway of no change in rates, there was plenty to suggest that the central bankers are not particularly happy with what they see in the economy as the second half of the year gets underway.

Dot Plot Tea Leaves

The FOMC’s Summary Economic Projections, colloquially known as the “dot plot,” reflected a change from the previous reading back in March, and the change was essentially in one direction: worse. Inflation is projected to be higher, and so is unemployment, while real GDP growth estimates are lower (bear in mind that these are just estimates, subject to changes in actual conditions not to mention good old fashioned human error). The picture isn’t exactly doom and gloom – the numbers don’t spell out a likely recession – but the median outlook for GDP growth in 2025 is 1.4 percent, down from the March estimate of 1.7 percent. Inflation, as measured by the Core Personal Consumption Expenditure index, is expected to register at 3.1 percent by the end of the year, up from the prior forecast of 2.7 percent.

None of this is particularly surprising, given that the March FOMC meeting took place before the full tariff-related mayhem that kicked off on April 2. But it is a good reminder that, even if we avoid the worst possible outcomes in terms of the tariff policy’s effect, economic conditions are likely to get worse before they improve. And it would not take much for exogenous events – be they another unwelcome tariff surprise, or a shutdown in the Strait of Hormuz that sends crude oil prices into triple digits, or something else entirely that isn’t on anyone’s radar screen today – to push weak economic growth into negative growth. The odds of a recession are lower today than they were on April 3, but they are not zero.

Two, One or None

The FOMC’s median estimate for the Fed funds rate for 2025 reflected two rate cuts between now and the end of the year, the same as the median estimate in March. So, no change, right? Not so fast. The median is simply the number smack in the middle of nineteen individual guesses. In March, four of the nineteen FOMC members projected that there would be no further rate cuts this year. In the June SEP, though, the number of “no more cuts” estimates rose to seven. Which makes sense, given the Fed’s commitment to bringing inflation back to the long-term two percent target, and given that it currently doesn’t see that target being finally reached until 2028.

The Fed meets again in July, but there won’t be another set of Summary Economic Projections until September. We expect the Committee members will have quite a bit of new data to digest between now and then, particularly with regard to inflation. As Fed chair Powell said during the post-meeting press conference on Wednesday (and as we noted in our commentary last week), the full effect of inflation from increased tariffs, which up to now has been relatively quiescent, is likely to come into view during the next several months. By the time the FOMC meets in September they may have a better sense of whether the higher inflation will be more transitory in nature or something to worry about for a longer time frame. If it looks transitory, then the focus will likely turn back to slower growth and higher unemployment, which in turn would give a higher likelihood of at least one, if not two of those rate cuts coming into effect. Either way, this is likely to be a very data-rich summer, with plenty of implications for portfolio positioning.

If you exclude that three-week period in April when the most draconian tariff regime since the beginning of the twentieth century was announced and then promptly reversed (technically put on hold, but does anyone really believe that 46 percent tariffs are coming to Vietnam on July 2?), the first six months of 2025 have actually been pretty humdrum. The S&P 500 is up about two percent from where it was at the beginning of January, while the 10-year Treasury note is hovering right around its average yield of 4.4 percent for this period.

Both stocks and bonds, in other words, seem to be registering a conviction that the worst of the potential economic hit is behind us, with a resumption of something like the cyclical trend that was prevailing prior to the whole tariff kerfuffle: a “soft landing” with growth slowing but remaining positive while inflation settles back to its two percent target. Are the markets correct in their composure, or are they premature in their assumption that all is well and back to the brandy?

Hard and Soft Converge

The optimists have a pretty good case to make simply on the basis of the available data. A few weeks ago we were writing about the divergence between so-called hard and soft data. Surveys such as the Consumer Confidence index, the Michigan consumer sentiment report and the NFIB small business sentiment index all plummeted amid economic uncertainty among households and businesses. The question we asked back then was whether the hard data, headlined by GDP growth, inflation and unemployment, was going to “catch up” with the doom and gloom vibes of the surveys. Now it seems like the trend might be going the other way. The latest Consumer Price Index report came out this week, and it showed core CPI (excluding the volatile categories of food and energy) at 2.77 percent, its lowest level in four years (headline inflation, which includes food and energy, was even closer to the two percent target at 2.8 percent). Last week’s employment report was also mostly fine, with payroll gains a bit better than expected and overall unemployment stable at 4.2 percent (though, as we noted in our report last week, the unemployment rate for recent college graduates is a potential source of concern). Meanwhile, the surveys have been trending up. The latest Michigan sentiment report, fresh off the presses this morning, registered a significant increase from last month and was well ahead of economists’ forecasts. The convergence, in other words, seems to be going in a positive direction.

Where’s the Inflation?

Is it surprising that higher inflation isn’t showing up? After all, despite the administration’s repeated backtracks from the direst of tariff threats, the overall tariff rate for US consumers is still, at around 20 percent give or take, higher than it has ever been since 1934. The rational expectation would be that the higher tariffs beget higher prices. Yet the month-to-month increase in prices from April to May was just 0.1 percent for both headline and core CPI.

The most likely explanation for the non-event of higher inflation to date is that many businesses ramped up inventories before the new tariffs took effect, and thus are able to sell their goods without undue price increases while maintaining stable profit margins. Evidence for this can be seen in the massive drop in imports recently – a 16.3 decrease in April from the previous month. But inventories run out in due time. That is why many economists believe that inflationary pressures won’t really kick in for another month or two, but that consumer-facing prices are likely to be higher towards the end of the summer. Maybe it’s a good idea to get your back-to-school shopping done well in advance of Labor Day weekend.

Another Geopolitical Wild Card

The news this morning of Israel’s large-scale attacks on Iran, targeting nuclear facilities, military sites and the residences of prominent leaders adds another variable to the equation. Generally speaking, markets are quick to regain equilibrium after unexpected geopolitical news breaks – witness for example the resumption in calm of commodity markets within days of Russia’s invasion of Ukraine in 2022. The immediate market reaction today is within the usual bounds – stocks down but not dramatically so, bond yields steady, and oil prices up sharply but retreating a bit from their overnight highs.

We don’t know yet the extent to which Israel intends to continue its attacks, or what its planned end game might be, but there is the potential that it could be a significantly destabilizing event. The World Bank has already projected that global growth will slow in 2025 to 2.3 percent, which is half a percent lower than what the Bank forecasted at the beginning of the year. That forecast is based on an assumption of oil at an average of $66 per barrel – so the implications of structurally higher prices for oil and other commodities do matter.

While we are impressed with the markets’ ability to remain cool, calm and collected in the face of all the first half uncertainty, there is still a long way to go before the end of the year, and plenty of challenges awaiting us around the next bend. This is not a time for relaxing one’s guard.

This week was Jobs Week, when we were afforded a fresh look at employment trends in the US, and the net takeaway was the proverbial mixed bag. The headline number for Jobs Week, of course, is the monthly report from the Bureau of Labor Statistics which contains, among other data points, the national unemployment rate and the gains or losses in nonfarm payrolls. That report, which came out this morning, showed a continuation of slowing payroll gains, the fifth month in a row in which payroll additions grew at a slower pace than the three-year average of 213,000. The overall unemployment rate, meanwhile, remained steady at 4.2 percent.

Earlier in the week, though, observers took note of a notable decline in payroll growth reported by the monthly ADP Employment Survey. This report had jobs growing by only 37,000 versus the consensus forecast by economists of 130,000, suggesting that the long-expected cooling off of the labor market may be further along than we thought. But wait, there’s more! The JOLTS job openings report came in better than expected at 7,391 openings versus the forecast of 7,100.

All in all, then, a mixed bag. But there is an underlying trend going on in the labor market that we think merits closer attention as an indicator of where things generally may be headed.

Graduate Blues

The headline unemployment number has remained remarkably steady over the past year, with one exception. Unemployment for recent college graduates started to spike up at the beginning of this year and rose sharply through the first quarter, as shown in the chart below (the latest data available for this segment is March 31).

As the above chart shows, unemployment for all workers (shown in crimson), for all young workers (green dotted line) and for all college graduates (purple dotted line) did not change much over the 15 months to March 31. But the rate for recent college graduates, which encompasses workers aged 22 to 27 years old, jumped by roughly a full percentage point. Now it is possible, of course, that this is nothing more than a mini-trend that will reverse itself in due course. On the other hand there may be something more durable going on here, and at least some observers imagine that “something” as having to do with AI.

Agentics Versus Alumni

If you happen to have tuned in to any earnings calls by Big Tech companies lately, you would probably have heard the word “agentics” spring forth from the lips of tech execs multiple times. In the world of leading-edge AI, agentics means the implementation of platforms capable of handling a wide range of service-sector functions from customer service to data analytics and the parsing of legal documents. In other words, functions that often align with the job responsibilities of new college graduates. Economists are starting to connect the dots between this relatively recent development in AI and those spiking unemployment numbers for recent grads. A research briefing published last month by Oxford Economics notes that “there are signs that entry-level positions are being displaced by artificial intelligence at higher rates.” As an aside, it’s worth noting that some of the jobs that could get swept up in the agentics revolution are some of the most sought-after for newly-minted holders of bachelor’s degrees, such as investment banking analysts.

That said, it is still too early to infer causation from correlation in observing these trends. A recent article in the Economist, for example, drilled into some of the details underlying this employment trend and concluded that, no, AI was not coming to take away your job.

Not yet, anyway. But that may change as adoption rates of leading-edge AI technology grow among businesses. Use of AI in core business functions is still something that fewer than ten percent of all businesses surveyed say they are doing. That could mean that Big Tech’s promises of what AI can deliver are overhyped and will fall short of projections, or it could mean that we are still in the early stages of an adoption curve that will grow and, at some point, tip into hyperscale across the economy. Meanwhile, keep an eye on those numbers for recent college grads.

Keeping up with the financial news is a tall order in this Year 2025 of the Common Era, which will almost certainly enter the logbooks of history as the Year of Uncertainty. Consider the week that is ending today. It started off, well, just fine, as far as things go these days. Those nasty 50 percent tariffs on goods imported from the European Union that the administration had announced just last Friday were, surprise of all surprises, delayed from a June 2 commencement to July 9. That nice little Memorial Day weekend treat got markets off on solid footing as the week got underway.

Or Was It All Just a Dream?

An actual surprise (as opposed to the government backing away from previously announced tariffs, which at this point should surprise absolutely nobody) came on Thursday morning with the announcement that the US Court of International Trade (did you know that this was a thing prior to Thursday?) had issued a ruling that the government could not use the Emergency Economic Powers Act to unilaterally implement tariffs without Congressional approval. As in – the base line 10 percent tariffs on everyone that were the remnant of the April 2 “Liberation Day” rates, along with the 25 percent hit to otherwise non-compliant goods from Mexico and Canada, and additionally the incremental tariffs on China – were all beyond the reach of the White House’s authority and were to be scrapped. Investors around the world resembled nothing so much as Dorothy, waking up in her bed on the Kansas prairie, staring at Auntie Em and asking, was this all just a dream?

Not so fast, of course, as nothing in Year 2025 can ever simply just be. By the end of the day yesterday an appeals court had issued a stay on the USCIT ruling, meaning that the administration could continue collecting tariffs for now while the US Court of Appeals for the Federal Circuit reviews the lower court’s decision. Which could mean…anything from a green light to an outright ban to a “this is okay, but that is not okay” parsing of the potpourri of tariffs. For businesses trying to plan their strategies, for the poor beleaguered officials whose job it is to actually collect and document tariffs (yes, there are people who do this for a living, and they all deserve some kind of public service medal for their efforts to stay sane when this is all said and done), the uncertainty continues.

899, Not So Fine

And then there was this nugget, buried in the thousand-page tax bill trying to make its way through Congress, that intrepid sleuths dug out for public consideration just this morning: a tax surcharge on foreign investors deemed to be citizens of a country with “unfair tax policies” – a designation encompassing everywhere from most of the EU to Australia, the UK, Canada and elsewhere. Investors from these countries, according to Section 899 of the “big, beautiful bill,” would pay additional taxes of 5 percent per year, up to a maximum of 20 percent, on dividends and interest from US stock and bond holdings (potentially including US Treasuries though the language on this is not clear in the bill).

In other words, for example, a foreign-owned company that wants to avoid punitive tariffs by investing in production facilities in the US could now be punished for that investment in the form of additional taxes on earnings flowing back to the home country. Which seems like a very strange way to reward companies doing what the administration appeared to want them to do in the first place – export less and build more here. This also comes at a time when, as we discussed at length in our commentary last week, the financial position of the US is more reliant than ever on foreign creditors buying our debt. Particularly long-term debt, where demand around the world is slacking and the bond vigilantes are riding high. Weaker demand for US debt will, all else being equal, raise interest rates, which will increase the amount the government spends on interest payments, which is already more than it spends on defense, Medicare and Medicaid.

Will Section 899 make it through all the sausage-making that will take place between now and the bill’s final form? Plenty of evidence continues to suggest that when the market speaks in a loud and unhappy voice, this administration backs off. The market – and its media mouthpieces – are speaking. The Economist magazine observes that Section 899 “would render America all-but-uninvestable for many foreigners.” Uninvestable is normally a term we associate with rickety frontier markets, not the 80 years-plus epicenter of global finance. Our policymakers need to deep-six 899 before it sees the light of day.

Sometimes the wry humor just writes itself. This week saw the House pass a tax bill going by the name “one big beautiful bill” – or “Triple-B”, as some of the Republican House staffers would refer to it in their back-and-forth messaging during the sausage-making process. Bond investors, always happy to latch onto a joke at some else’s expense, piled onto the Triple-B moniker – BBB, of course, is the lowest rung on the investment grade credit scale before descending into the funhouse of junk bond ratings. As in: that’s where American government debt – the world’s long-enduring proxy for a risk-free rate –could eventually be headed if this bill makes its way into law. Passage is not yet a foregone conclusion, as the bill will have to make its way past some potentially ornery opposition in the Senate before it gets to the president’s desk. But given the current state of Republican politics and the administration’s overweening desire to see this thing to the finish line, it’s a pretty good bet that something very close to the current plan will manage to arrive at 1600 Pennsylvania before too long.

20-year Bond? Anyone?

The latest opposing salvo from the bond market came on Wednesday this week when a $16 billion auction of 20-year Treasury bonds, in the face of weak demand, went out at a yield of 5 percent. The 20-year maturity is a relatively recent addition to the Treasury stable, introduced in 2020, and this week’s auction represented the highest yield for a new offering.

On the same day as the tepid 20-year offering, yields on the bellwether 30-year bond reached their highest level since 2007. At the same time the dollar, which had been finding some strength in recent days thanks mostly to the apparent de-escalation of the trade war, resumed falling, and conditions started to look a lot like those dark days in the immediate wake of the April 2 tariff announcements (as we are writing this on Friday morning, those kinder and gentler trade headlines of late are coming under renewed fire with a new announcement by the administration of 50 percent tariffs on products from the EU and 25 percent tariffs specifically on any Apple iPhones not made in the US. Ugh.).

Gently, then Suddenly

To be clear, the bond market’s reaction this week has been more of a gentle nudge than a violent shove. Yields on intermediate and long-dated maturities have settled back down a bit from where they were in the immediate aftermath of the 20-year auction on Wednesday. There may be some hedging going on as investors speculate on whether there might be more meaningful pushback from the Senate before the Triple-B tax act gets written into law (a sentiment we do not share, given that the main force likely to push up debt and attendant deficits will come from the extension of the 2017 tax cuts, and we see little to no likelihood of those being pulled out or tampered down by anyone in this Congress). In general, movements in the bond market tend to be more measured and gradual than the more volatile day-to-day lurches we often see in the stock market.

Our concern, though, is that at a certain tipping point things can start to unravel quickly. What might that tipping point be? Some observers think that if the 10-year breaches five percent then we could see a much more pronounced pullback, along with plummeting demand for new Treasury issues making this week’s 20-year auction seem quaint by comparison. We’re not convinced that five percent – which is only 0.5 percent away from where yields are today – would be that dramatic of a trigger. We agree, though, that there is an event horizon out there beyond which we have no desire to travel.

That famous line from Ernest Hemingway’s “The Sun Also Rises” comes to mind, when a character named Bill asks another, Mike, how he went bankrupt. Mike replies “gradually, then suddenly.” We hope that our policymakers will heed the bond market’s gentle nudges and take appropriate actions before they turn into shoves of a more sudden and unpleasant nature. Meanwhile, our bond market mantra is simple: keep your credit quality high, diversify where possible, and think shorter duration.

Every calendar quarter, we publish a survey of markets and the economy for our clients called the “State of Play.” One of the standard features of this quarterly report is a time series snapshot of four headline macroeconomic trends over the past five years. The significance of this span of time is that it was exactly five years ago when the economic shutdown forced by the global pandemic threw a spanner into our neat little set of trendlines for employment, GDP growth and the like. Suddenly, those incremental month-to-month and quarter-to-quarter changes were disrupted by the most seismic shifts on record. In the second quarter of 2020, US real GDP growth declined by 28.1 percent. In the third quarter it rose by 35.2 percent. Compare those numbers to the average real GDP growth rate for the past three years, of 2.4 percent, and you can see how those Covid-era numbers threw our orderly State of Play charts out of whack.

Incentives Now, Consequences Later

Now, we are not going to say that a month-on-month decline of 0.4 percent in the Producer Price Index, bringing the year-on-year growth rate down nearly a full point from 4.02 percent to 3.05 percent, is in any way as distortive as that 2020 freak show of data gyrations. It does stand out among its recent peers, though, as the chart below shows.

While not as extreme, the April PPI number does share a narrative of sorts with the pandemic data in that the change, which was much larger than what economists had forecast, could be placed on one single cause. In this case, of course, the cause was the derecho storm of tariff policies announced (and revised, and revised again and again) between the March and April PPI surveys.

Think of the PPI as being “upstream” from its sister metric, the Consumer Price Index. The PPI, also called the Wholesale Price Index, tracks changes in prices that businesses receive for their goods and services. Manufacturers have choices to make in determining how much of the cost increases they face from higher input costs (raw materials, labor and the like) they pass on to consumers. What the sharp monthly decrease in the April PPI number shows is that, for now anyway, businesses are swallowing much of these input costs themselves, settling for lower profit margins as they try not to lose customers with higher end prices. Maintaining volume in sales is the incentive to refrain from passing on costs. But that strategy can only last for so long, and chances are that the coming months will look quite different.

Walmart’s Warning

How soon will those higher prices start showing up at the retail level? Pretty soon, according to Walmart. The big box behemoth released its first quarter earnings report this week, and amid what was overall a healthy outcome for Q1 was a warning that consumers will start to see higher prices on the shelf as soon as the end of this month. The company noted that it has been trying to keep prices low (for the same reason that manufacturers have been eating their higher input costs) but that, in an industry with characteristically low profit margins, they will need to offload more of that burden onto consumers.

What has been missing in much of the financial reporting this week on the “relief” resulting from the Trump administration’s abrupt decision to lower tariffs on Chinese goods to “only” 30 percent is that, well, 30 percent is only a relief in the sense that 30 is a lower number than 145. It still amounts to a sizable cost increase. After all the to-ing and fro-ing in this administration’s policy changes, the average global tariff rate on goods imported into the US is still over 17 percent, higher than at any time since 1934, when the unfortunate Smoot-Hawley tariffs were in effect. And we still have no idea what things will look like after all the various 90-day “pauses” have lapsed. Or what brilliant new ideas the engineers of the tariff program will come up with in the meantime.

Economists have been backing off some of their most dire forecasts for a recession later this year. We’ll see about that; meanwhile, however, the stagflation recipe of higher prices and lower growth remains a pretty good bet, in our opinion. We may be due for a reverse of the hard data / soft data trend of the past several months, in which consumer and business sentiment starts to improve – hey, 30 percent is pretty good by comparison! – while inflation, employment and growth data start to turn south. We’re not out of the woods yet.

We sometimes refer to productivity as “the most important macroeconomic data point that nobody pays attention to.” That’s in contrast to the holy trinity of jobs, inflation and GDP growth, the three reports that generate the most chatter among financial media types. The productivity report for the first quarter came out yesterday, but unless you were deep into the economics pages of the Financial Times or the Wall Street Journal, its coming and going would have passed you by. That’s a pity, because in the long run our economic prosperity depends on growth, and in our demographically challenged times, the only path to sustainable growth runs through productivity. The population growth rate is in decline, and with a growing ratio of deaths to births, the percentage of the population in peak working-age years is declining. Either we grow through increased productivity, or we don’t grow – it’s that simple.

With that in mind, it wasn’t great to see productivity decline in the first quarter by a greater than expected minus 0.8 percent (annualized) from last year’s fourth quarter, marking the first quarter of negative growth since 2022. Let’s take a big picture look at how we got from earlier economic cycles to where we are today.

Making More with Less

There are several technical definitions for productivity, but the underlying concept is always the same: making more stuff with less expenditure of effort, time and money. The importance of this metric was one of the key insights Adam Smith described in his seminal 1776 tract “The Wealth of Nations,” explaining how a pin factory could massively increase its daily output through the implementation of specialized labor processes. That was in the earliest years of the Industrial Revolution; one hundred years later, the manufacturing enterprises of Great Britain and the United States were achieving productivity gains at a rate commensurate with Smith’s pin factory on steroids.

Productivity in the US continued to grow at a brisk clip through much of the twentieth century. After the Second World War the Bureau of Labor Statistics started measuring productivity gains, and through the first quarter century of so after the war, the average rate of productivity growth from quarter to quarter was around 2.7 percent (annualized). US manufacturing dominated the world, and organizations learned how to optimize their production processes at a scale that would have been previously unimaginable.

Productivity growth started to fall off sharply in the early 1970s, though, and apart from a brief resurgence in the early 2000s (largely seen as the impact of Information Age innovations), it has lagged ever since. The chart below shows that from 2021 to the present, the average growth rate was just 1.09 percent. That is more than two and a half times less than that 2.7 percent growth rate from 1947 to 1973.

Is AI the Answer?

What’s the recipe for improving productivity? Opinions vary among economists. There is one school, perhaps best represented by Northwestern University economist Robert Gordon, that deems it unlikely we will ever see the kind of productivity growth we enjoyed in the middle years of the last century. In his book “The Rise and Fall of American Growth” Gordon argues that the productive power we got from the critical inventions of electricity and the internal combustion engine are unlikely to ever be repeated, and we’ve already squeezed as much as we can out of those.

Others, however, point to the observed fact that there is usually a time lag between a new invention and that invention’s translation to commercial gain. Consider electricity; it was invented in 1879, but in 1919, forty years later, only half of American houses were connected to the grid. More recently, semiconductor chips had been around for more than forty years before we saw that brief Information Age productivity surge in the early-mid 2000s.

With this in mind, perhaps it is not surprising that many of the productivity optimists among us today point to artificial intelligence. After all, it has been a scant two years since ChatGPT burst onto the scene, launching a public fascination with AI and, of course, the stock market craze that drove much of the upside in those two back-to-back 20 percent-plus years on the S&P 500 in 2023-24. We know that, despite all the excited chatter, less than ten percent of all businesses claim to have AI-driven processes deep into their business models. Perhaps it will just take a bit more time before the effects show up in the productivity numbers. It would be nice to think so, because the growth isn’t going to happen all by itself – and it isn’t going to happen from whatever is passing for economic policymaking in Washington these days.