How to read Trump’s budget

Now we know the numbers: both Houses of Congress have passed the President's Big, Beautiful Bill (BBB) which sets out his spending and taxing plans for the rest of his term. The legislation rolls over the substantial income and business tax cuts of President Trump's first term, which were otherwise due to expire. It adds in his latest tax reductions, promised in his 2024 election campaign, taking the tax off overtime and tips as well as increasing tax relief for business investment. It sets out big rises in defence spending to create a Golden Dome or anti-missile and drone defence for the USA, to develop the next generation fighter plane and add to the arsenal of drones and ammunition. It provides a substantial boost to spending on defending and closing the borders, adding 701 miles of new border wall and recruiting more enforcement officials. It offsets some of this by substantial cuts on green financing and projects, agency and government overhead and selected cuts in the education and health departments. 

Tariffs are the wild card

The budget and legislation went through without agreed detail on how much tariffs might raise and what impact tariff policy will have on output. Tariff policy is still violently gyrating between the threats of ultra-high tariffs on various important trade partners, and more realistic higher tariffs that markets can live with. Clearly the President wants to get better deals than trade partners are so far willing to offer, so he continues to threaten. It seems likely that tariffs will settle well above the low average level of last year, at more than triple the past average. As a result, they will bring in more revenue than currently in the numbers, providing some offset to the deficit. However, many fear that tariffs could slow growth and disrupt bond markets, raising the cost of borrowing.

How dangerous are large deficits? 

It has been common for the US to run large deficits, and to get away with it. As a sovereign country with its own Central Bank, the US need never default on its debts as it can always create dollars to pay the interest. This would also help inflate away the real value of the debt. 

US debt has been seen as a safer asset than many other bonds and shares, even during times of high US borrowing and high inflation, but this could all change: the higher the outstanding debt pile rises, the more danger there is in the system. At over 100% of GDP, the state debt now costs significant sums to service. If borrowing rates stay high and the government keeps selling more bonds, inevitably debt interest burden becomes a larger and larger percentage of the budget and the economy. The point of maximum immediate danger was the passage of the budget, yet markets seem to have accepted the high deficits implied for now, merely reflecting these in relatively high rates of interest. 

Congressional Budget Office (CBO)

These relative high rates of interest are a major concern for the CBO. Their figures show debt interest surging from under $1 trillion to $1.8 tn by 2035. At the same time, they see social security and Medicare costs continuing to rise sharply. It seems unlikely these higher costs coupled with relatively low taxes will persist throughout the decade. A successor to Donald Trump would be told to rein in expenditures or expand tax revenues to keep the markets happier. On the other hand, it is always possible that the CBO is understating tax revenues under this presidency, as higher tariff revenue and more tax from growth may well soften the impact. 

Checks and balances for the BBB

If President Trump settles with trade partners for substantially lower tariffs than currently proposed, there could be a growth bonus as well as more help from market sentiment to keep borrowing costs down. If he follows through with higher tariffs there will be more revenue but less growth, requiring the Fed to cut rates more. Joe Biden got away with a large reflationary package of spending and green investment. Donald Trump may well get away with lower taxes and higher defence spending as he seeks to onshore much more investment into the USA. 

US interest rates on government debt are higher than China, a lot higher than the main EU countries are paying, and well above Japan's, which has a much higher debt to GDP. These rates offer some attractions to many investors who do not think the US is about to get into debt trouble. Most analysts and the Fed anticipate modest cuts to the short-term interest rate over the year ahead, assuming inflation remains under control. Whilst higher tariffs will in part be a tax on US consumers, nudging up the price level of some goods, they only become an inflationary problem if that follows through to higher wage settlements. The Fed would need to relax more to allow an inflationary spiral to set in, which it does not wish to do for now. 

Conclusion

There are positives for equities in the BBB, which many overlook as they worry about tariffs and borrowing levels. The lower taxes, deregulatory policies and the promotion of much more onshore investment are helpful to US business and are likely to mean US growth continues to outperform European and Japanese prospects. As the US dominates the development of digital business and artificial intelligence outside China, business in the rest of the world will be spending more with the US digital giants in the years ahead. 

The overall impact of the budget will be higher bond coupon rates for longer as the Fed seeks to ensure inflation does not take off again. The bond markets will need to supply large sums to keep the government in funds, and investors in US bonds can enjoy a better rate of interest than many other government bonds on offer around the world. Meanwhile, as quantitative tightening slows, the bond market will benefit from a reduction in the pace of run-down of the Fed's bond holdings, which had been a large force in driving bond prices down.

About the author 

The Rt. Hon Sir John Redwood has been a long-standing member of the EPIC Investment Partners Advisory Board. 

John is a well known commentator on governments and economies, with long experience of investment markets. Trained as an analyst at Robert Flemings, he moved to N.M. Rothschilds where he became a Manager and Director of pension and charitable funds and Head of Equity Research. He was seconded to become Head of the Downing Street Policy unit before chairing a large, quoted UK industrial business. He served as an MP and a government Minister.  

In 2007 he set up Pan Asset with a colleague, an investment management business that pioneered active/passive funds and models in the UK. Following the sale of the business to Charles Stanley, a quoted investment manager in the City, he became their Global Chief Strategist advising on non-UK markets and economies. He also ran a demonstration fund for the FT, writing articles about it and illustrating the use that can be made of ETFs in portfolios. 

He is now an adviser to EPIC, providing insights into the big investment issues of the day from the debt and spending problems of the major governments to the green and digital revolutions which have so much impact on equity markets. He is a Distinguished Fellow of All Souls College, Oxford, where he helps with their Endowment investments and gives occasional lectures on modern economics and politics.