Introduction
In the midst of escalating geopolitical and economic risks, the U.S. stock market remains buoyant, raising concerns about its vulnerability to a sudden shift in sentiment. This situation bears resemblance to the period preceding World War I, when geopolitical upheaval was evident, yet the stock market thrived.
Geopolitical Risks
The current geopolitical landscape is fraught with instability. Europe grapples with its most significant land war since World War II, while violence and unrest resurface in the Middle East. Furthermore, U.S.-China relations have deteriorated to their worst point, potentially impacting the steady supply of Taiwanese semiconductors to the U.S.
Economic Risks Within the U.S.
Domestic economic risks are on the rise, largely due to President Trump’s policies. High import tariffs will diminish the long-term competitiveness of the U.S. economy and hinder the benefits of international trade. Mass deportation measures will also strain domestic production and elevate costs, particularly in agriculture and construction.
Fiscal Health Under Threat
Trump’s policies are jeopardizing the fiscal health of the U.S. Before Trump returned to the White House in January, the U.S. was on an unsustainable fiscal trajectory. According to the Congressional Budget Office (CBO), the U.S. budget deficit reached 6.4% of GDP last year, despite near-full employment. Had this trend continued, the debt-to-GDP ratio would have risen to 118% by 2035.
However, this is now projected to occur sooner due to the Tax Cuts and Jobs Act signed into law last month. The CBO estimates that this extensive fiscal and healthcare legislation will add $3.4 trillion to the budget deficit over the next decade. The Committee for a Responsible Federal Budget places this figure above $4 trillion, increasing the public debt to at least 125% of GDP by 2034.
Dependence on Foreign Investment
The U.S. economy’s fundamental vulnerability lies in its reliance on foreigners to finance its dual budgetary and trade deficits. Foreign investors currently hold nearly a third, or $8.5 trillion, of the $28 trillion in U.S. Treasury bonds in circulation. For foreign investors to continue financing U.S. debt, they must trust the country’s commitment to its debt obligations rather than attempting to inflate or default on payments.
Eroding Investor Confidence
Trump seems to be actively undermining foreign investors’ confidence in the U.S. He is aggressively pressuring the Federal Reserve to cut interest rates aggressively, despite the likelihood of rising inflation due to his tariffs. Moreover, Stephen Miran, Trump’s former Council of Economic Advisors chair and current nominee for a temporary seat on the Federal Reserve Board, proposed forcing foreign investors to convert their Treasury bonds into 100-year, non-coupon bonds. The Trump administration has also considered imposing a 20% tax on interest earned by some foreign bondholders on their Treasury notes. Trump’s recent dismissal of the Director of the Bureau of Labor Statistics following disappointing employment data has only exacerbated investor concerns.
Potential Consequences
Should foreign investors’ confidence in the U.S. plummet, dollar-related and bond market crises would ensue. Indeed, the dollar’s value has already dropped around 10% since the beginning of the year, despite increased import tariffs and widened short-term interest rate differentials with other major economies. Bond yields have risen, suggesting the U.S. Treasury market is no longer perceived as a safe haven. Meanwhile, gold prices have surged approximately 25%.
Historical Precedents
Stock market valuations remain elevated, reminiscent of the dot-com bubble’s peak in 2001. As economic historian Niall Ferguson noted, the stock market thrived before World War I despite clear signs of geopolitical disintegration.
The Author
Desmond Lachman, a research fellow at the American Enterprise Institute, was Deputy Director of Policy Development and Review at the International Monetary Fund and Chief Economist for Emerging Markets at Salomon Smith Barney.
Key Questions and Answers
- Q: What are the current geopolitical risks facing the U.S.? A: The U.S. faces escalating tensions in Europe, unrest in the Middle East, and strained relations with China, which could disrupt crucial supply chains.
- Q: How are Trump’s policies impacting the U.S. economy? A: High import tariffs, mass deportations, and potential fiscal recklessness threaten the U.S.’s long-term competitiveness and fiscal health.
- Q: Why is the U.S. stock market vulnerable? A: The market’s detachment from geopolitical and economic risks, coupled with reliance on foreign investment, makes it susceptible to a sudden shift in sentiment.
- Q: What historical precedents exist for today’s stock market valuations? A: Similar to the period before World War I, the stock market thrived despite clear signs of geopolitical disintegration.
