Chief Global Strategist
One of the more challenging positions in football is that of place kicker for the visiting team. In theory, the job is simple – boot the ball through the middle of the uprights. However, there is a raucous crowd cheerfully doing its best to distract you. There are often swirling winds or other elements of nature ready to divert the football from its target the moment it leaves your foot. And there is a menacing group of large young men, just a few feet in front of you, who are anxious to block the ball or, as a very acceptable alternative, plant you in the mud. Your job is to ignore the distractions, distortions and threats and focus on the matter at hand.
Long-term investors in 2025 face a similar set of distractions, distortions and threats. There is a constant barrage of news on the Washington shutdown, the deployment of the national guard, stepped-up immigration enforcement, global conflicts and on-going trade wars. Partisan cable shows, amplified by a malicious and curated social media scroll, are heightening the confusion even as the shutdown of government agencies is depriving the public of a normal, more balanced, stream of economic data. Meanwhile, spurred on by AI enthusiasm, valuations for large-cap U.S. equities are approaching the extremes seen in the dot-com bubble of 25 years ago.
Amidst all of this, the job for investors is to focus on the trends that actually determine long-term returns. We will be discussing many of these in our 2026 Long-Term Capital Market Assumptions, due out next week. However, in the meantime, as we embark on a new federal government fiscal year, it is worth taking a look at one important long-term theme, namely, what is going on with the federal debt and how the steady deterioration of U.S. government finances could impact asset class returns.
The Near-Term Outlook
Last Wednesday, the Congressional Budget Office (CBO) released its estimates of the federal finances for the just-ended fiscal 2025 (FY2025). At first glance, the deficit, at $1.809 trillion, or 6.0% of GDP, looks like a slight improvement from FY2024’s $1.817 trillion, or 6.3% of GDP. This is particularly the case because the FY2024 figure would have been $1.889 trillion had it not been for a calendar quirk at the start of that year. However, the FY2025 numbers benefitted from a somewhat artificial $234 billion reduction in outlays due to changes in the capitalized value of federal student loan programs. Without this reduction, the deficit would have been $2.043 trillion, or 6.7% of GDP.
We expect this fiscal year to produce an even higher deficit. While, according to CBO estimates, the OBBBA was expected to add $126 billion to the FY2025 deficit, (excluding the student loan reduction break), it was calculated to boost the FY2026 deficit by $277 billion1. If anything, this may now be an underestimate, as virtually all of the new personal income tax breaks that became effective, retroactively, on January 1st of this year, are now expected to boost refunds in FY2026 rather than lower withholding in FY2025.
Elsewhere, we assume tariff revenues average $36 billion per month between now and next September (they have averaged $29 billion over the past three months) and pencil in roughly 4.5% nominal GDP growth over the next year. Net interest outlays, which amounted to roughly $980 billion in the last fiscal year, could grow to $1.046 trillion in the current year, as a rising stock of debt offsets a stabilization in the relatively slow-moving average interest rate paid on that stock. Under this scenario, the deficit climbs from $1.809 trillion, or 6.0% of GDP, last fiscal year to $2.132 trillion, or 6.7% of GDP this year.
It's worth pausing here to consider this number. The total federal debt in the hands of the public is now almost $30.3 trillion or, we estimate, 99.9% of GDP. Starting from these levels, if nominal GDP grows by roughly 4.5% going forward, (comprised of 2.0% real growth and 2.5% inflation), then any budget deficit north of 4.5% will cause the debt-to-GDP ratio to rise. Under our assumptions, the debt-to-GDP ratio climbs from 99.9% on September 30th, 2025 to 102.2% of GDP 12 months later.
There are good reasons to believe, however, that the debt will rise even faster than this.
First, this baseline scenario assumes the government continues to collect very significant tariff revenue each month. This assumption could be negated if the Supreme Court rules, in the next few months, that the tariffs the President imposed by invoking the Emergency Economic Powers Act of 1977 are, in fact, illegal. This would, at a minimum, force the administration to go back to the drawing board to impose replacement tariffs under some other authority or by sending a bill through Congress. Moreover, it could force substantial refunds of tariffs already paid in recent months.
Second, while we expect a surge in income tax refunds to temporarily boost demand early next year, this boost will fade quickly once the refunds have been spent. This might entice Congress to provide further stimulus in the form of “tariff refund checks”, or some other device, to give the economy more bounce heading into the mid-term elections.
Finally, this all assumes no recession and no need for other major spending on domestic or international priorities. Because of all of this, a deficit equal to 6.7% of GDP should probably be regarded as a low-ball estimate of this year’s red ink.
The Long-Term Outlook and Investment Implications
In theory, the deficit should remain fairly stable in FY2027 and FY2028 and them pull back some in FY2029, as temporary tax cuts in OBBBA expire on December 31st, 2028. However, no experienced observer of Washington politics would assume that these breaks will expire on schedule and so a reasonable baseline forecast would be for the deficit to range between 6% and 7% of GDP into the next decade, boosting the debt-to-GDP ratio by roughly two percentage points each year.
However, even this may be too optimistic as it assumes uninterrupted economic growth and, more importantly, that despite populism from both the right and the left, Congress finds the discipline to avoid both further tax cuts or expanded government programs. A more likely scenario is that, either due to an emergency or a recession, the deficit ratchets up to 7% or more of GDP, leading to an acceleration in federal debt accumulation.
Some have argued that easier monetary policy could slow this debt expansion and it is true that net interest payments accounted for more than half of the total deficit in the last fiscal year. However, an overly easy monetary policy could lead to both a lower dollar and higher inflation, boosting long-term interest rates and eventually forcing much more painful monetary tightening.
The question I am asked most frequently by investors and financial advisors is when is the federal debt going to blow up in all of our faces. My usual answer is that, while we are going broke, we are going broke slowly. Global bond markets are very well aware of the trajectory of U.S. debt. The fact that even today, the U.S. government can borrow money for 30 years at a yield of just 4.6% speaks to a conviction that there remains room for the government to borrow more.
That being said, there is a danger that political choices lead to a faster deterioration in the federal finances, leading to a backup in long-term interest rates and a lower dollar. Based on current allocations and valuations alone, many investors should likely consider diversifying their portfolios by adding alternative assets and international stocks. The risk that we move from going broke slowly to going broke quickly adds an important reason to make this move today.