Tariffs, Debt, and Servicing: Navigating the Year Ahead

A slightly different format for this week: the performance review for Q2 and YTD is shown in the “Market Summary” section and covers a select group of financial asset classes.

Having reached the halfway point, where to from here? Three factors will be key for all economies, especially for the US: Tariffs, Total Debt and Debt-Servicing cost. Assuming trade negotiations settle at 15% tariffs (which is currently where they are), then the impact of these three is shown below:

There is a further complication here: ordinarily, the total debt pile is eroded away by REAL inflation. The latter is defined as: REAL INTEREST RATE = NOMINAL YIELD minus INFLATION. In this case, the result is positive (nominal yield = 5.1% to 5.3% and inflation is 3.7%) meaning debt is not being inflated away – instead, it is paying a positive, real rate on new and rolled-over debt. It’s growing! This is the irony – as destructive as inflation is on the asset side, it is also a destroyer of debt. We saw this in the 1970s. However, if you let nominal yields exceed inflation, the opposite effect arises.

This year, some 33% of outstanding Treasury debt matures (= circa$9.2tn). In 2026 it is about 6.5% (= circa$2.0tn). After that, it tapers – but is still high. 2025 is a key year – and will likely push term premia much higher thus taking its toll on long-duration bonds i.e. making them even more expensive. In turn, this will impact the psychology around auction demand – such things are never linear. It also begs the question, what will be the nature of the funding – short-dated issuance or longer? The latter will determine the shape of the Yield Curve (likely to become inverted again as shorter dated yields rise disproportionately higher vs medium and longer dated). It will also increase the risk of mismatch i.e. long-term spending being funded by short-dated funding.

So how do the US – and other nations – get through this? Given the obsession of Central Banks to keep inflation in check, it will instead require a combination or one or more of the following, most likely all three:

1. 1. Boost GDP: the OBBB (One Big Beautiful Bill) will certainly help as it contains a myriad of tax breaks – some are extensions of the TCJA and others are new such as no taxation of tips, etc.). As with previous administrations (e.g. Reagan-era tax cuts of 1981 and Obama’s ARRA in 2009), these measures are quick but only temporary because eventually the perks run out. The boost to GDP is in the order of 1% to 1.5%. This takes GDP to a little over 2%. This is still less than half the desired level. 
   2. Cut spending: From the outset, there has been controversy around DOGE. DOGE’s own estimates say $160bn has been saved. However, only $16bn has been verifiable. Independent studies show a very different picture and claim it will actually cost the taxpayer some $135bn! The primary saving has to come from spending, especially mandatory programmes (Social Security, Medicare, Medicaid….these total $3tn!). There is little to be saved from Departmental spending – the biggest of which is Defence at $900bn pa. The latter goes against Trump’s ideological standing. Spending cuts have an immediate and direct impact on the primary (i.e. pre-interest) deficit. It’s highly sensitive and can backfire. Look at the situation in the UK right now with the government U-turn on welfare cuts! They can lead to austerity at a time when economies are already soft. 
   3. Productivity: by definition, this is output divided by labour. Labour is declining on the back of migration policy – so this leaves output. The answer has to be technology and will require continued investment. This is the most powerful, long-term solution. By raising output per worker, one raises potential GDP and real wages without inflation. Enablers of productivity are AI deployment, infrastructure investment and upskilling. As an idea, even a +0.5% increase in productivity growth can reduce Debt/GDP by some 20% over a decade! It was the post-WWII US productivity boom (1947 to 1973) that helped pay down wartime debt. In the 1980s, the IT revolution provided a second wind to US growth without high inflation. 

 In summary, regardless of country and region, all will need to pursue a combination the above. The proportions will vary based on their circumstances and politics. In the process, this provides opportunities for investing – as alluded to in last week’s weekly (and previous ones) and is reproduced below:

• Thematic long positions: technology, infrastructure, commodities – these are the building blocks of any nation and its route to getting things done.
• Yield: In liquid markets, this is becoming very challenging given the upward pressure on yields (see comments long-duration bonds). However, private markets are a whole different story. My favourite is short-duration (up to 2 years) and can deliver 8% to 12%. Durations range from 2 months at the very low end to 6 months. On a duration-adjusted basis, these are extremely attractive and reduce exposure to interest rate-sensitivity (see “Hedges”).
• Hedges: Gold! Always a good one should the world fall apart….and if it doesn’t, don’t worry because leading Emerging Market Central Banks continue to buy it up. Other ways to hedge? As already mentioned above (“Yield”), keep your duration short (max 2y to 3y) to reduce interest rate sensitivity. The degree of time horizon is also clearer. Beyond two years, it’s a thumb suck! Commodities (selectively) provide a natural hedge to the US$. Oil has had its day – the best it could do was to bounce to the mid/upper $70 range during the Iran-Israel spat. The transition to alternative energies is becoming faster.

MARKET SUMMARY…

Some observations worth highlighting:

1. FX: There is a definite US$ correction taking place as implied by the EM FX Index. Though not shown on there, the US$ Trade-Weighted Index conveys the same message.
2. Energy: After a brief spike during the height of the Israeli-Iranian conflict, oil prices very quickly collapsed back to their usual lows (mid-$60s). This will help reverse imminent inflationary concerns (primary and secondary).
3. Precious Metals: Gold, Silver, Copper, Platinum….are all flying! The latter two are very much a lack of inventory story while Gold is a central bank story particularly amongst certain Emerging Nations.
4. Countries/Regions: Germany, Spain, Italy, China & Brazil are standout performers…..
5. Sectors: …..Mag-7 had quite a comeback to finish positive YTD. If you missed that by being uninvested, then you took a big hit. The wider Nasdaq is a similar story.
6. Bonds: gained across the board to differing degrees. Like sectors, these gains were against a background of weakening US$ so, for non-US$ portfolios, the  gains were even better in local FX terms