The late-summer calm in financial markets shows an undercurrent of optimism. Stocks have been on a tear, with the S&P 500 rebounding strongly to notch roughly 18% gains for the year, while overseas equities are up even more.
Major indices have powered to new recovery highs thanks to robust earnings and hopes that policymakers will keep the punchbowl flowing. Indeed, in the near-term markets remain buoyant and could stay that way, supported by a confluence of pro-growth policies and easing anxieties about interest rates. But this sunny short-term picture has its shadows. We see gathering risks that could spark a medium-term correction – chiefly the lagged bite of recent trade tariffs and policy uncertainty that has companies hesitant to invest.
Still, even if growth sputters, we expect any slowdown to be transitory. Washington continues to step on the gas with fiscal stimulus and deregulation, providing a powerful backstop that should re-accelerate the economy after a brief dip. The flip side is that these very measures sow the seeds of future challenges: long-term, the policy mix points to higher inflation and an era of negative real interest rates. In effect, the U.S. may increasingly rely on quietly “repressing” financial conditions – keeping rates below inflation – to manage its towering debts. In this update, we unpack this trajectory: from today’s market strength, through the potential correction and rebound, to the ultimate consequences for prices, rates, and investors.
At present, markets are displaying remarkable strength. After a wobble earlier in the year, equities have rallied hard over the spring and summer, leaving indexes near record territory. The S&P’s surge off the April lows led by tech high-fliers and even a renaissance in small-cap stocks – has restored confidence and then some. By the end of August, U.S. stocks were up in double digits year-to-date, and foreign bourses even more so. Credit markets have been cooperative as well: corporate bond yields remain contained, and volatility has ebbed, creating an environment where risk-taking is being rewarded. Several factors are driving this exuberance.
First, fiscal policy has turned decisively expansionary, delivering a jolt of adrenaline to the economy. The passage of the massive “One Big Beautiful Bill Act” in June – a sweeping $2.4 trillion package funding everything from border security to infrastructure – signaled to markets that Washington is willing to spend freely to keep growth on track. This bill alone is pumping roughly $350 billion directly into projects and programs, and it came paired with an increase in the debt ceiling that removed any immediate constraints on federal spending. The result is a pro-cyclical fiscal thrust rarely seen in peacetime: the budget deficit for fiscal 2025 is projected at about $1.9 trillion, or 6.2% of GDP. That kind of stimulus – far above historical norms – is helping buttress corporate earnings and consumer spending, even as the private economy works through some softer patches.
At the same time, investors are increasingly convinced the Federal Reserve will stay friendly. With inflation gradually moderating from its peaks and growth data mixed, expectations have grown that the Fed’s next move is an interest rate cut rather than another hike. In fact, following a late-August speech by the Fed Chair emphasizing rising unemployment and “balanced” risks, futures markets quickly priced in better-than-even odds of a rate cut by the Fed’s September meeting. While that proved overly optimistic – the Fed hasn’t moved quite that fast – the message was clear: the era of ever-tightening policy is likely behind us. This dovish shift in rate expectations has been yet another tailwind for equities, supporting lofty valuations on the premise that the cost of capital will stay low or start falling. In short, the near-term backdrop remains very favorable for markets. Earnings are holding up, liquidity is ample, and both fiscal and monetary policy are aligned in a growth-friendly stance. Barring any major surprises, this momentum could carry forward in the coming months, keeping asset prices well bid.
Over the medium term, however, we see storm clouds forming. The first and most obvious risk is the delayed impact of recent trade actions and political uncertainty. Earlier this year, the U.S. administration enacted sweeping new tariffs – reminiscent of 1930s-era protectionism – on a range of imports, aiming to reduce trade imbalances. While markets mostly took these in stride initially, the real economic effects tend to surface with a lag, and we suspect that lag is about to catch up. The International Monetary Fund recently warned that President Trump’s tariffs and the unpredictability surrounding them have significantly darkened the global outlook. Global growth for 2025 is now projected at just 2.8%, down from 3.3% a few months prior, and U.S. growth forecasts have been slashed as well – to around 1.8%, versus nearly 2.7% expected previously. In practical terms, this means a considerable loss of economic momentum heading into 2026. Business leaders, faced with ever-shifting rules on trade, are growing cautious. The IMF notes that many companies are holding back on capital investments and expansion plans amid the uncertainty, waiting to see how trade policy shakes out. Such a precautionary pullback could hit manufacturing and corporate earnings in the coming quarters. Surveys already show forward capital expenditure intentions weakening. Should this trend persist, it would undercut one leg of the bull case for stocks – robust corporate investment – and could bring equity valuations back down to earth.
Another issue is that the tariffs, by design, raise import costs and disrupt supply chains. This supply shock is feeding through into higher prices at a time when inflation was finally inching down toward the Federal Reserve’s 2% comfort zone. Early evidence backs this up: input prices for manufacturers have jumped, and consumer goods from affected countries are getting pricier on store shelves. Ironically, the very fiscal boost that is propping up growth is also adding fuel to prices – a classic case of too much money chasing too few goods when trade frictions constrain supply.
The risk is a mild stagflation: slower growth and higher inflation heading into 2026. This is a nasty combination for risk assets because it complicates the central bank’s response. If growth sputters but inflation is rising, the Fed faces a dilemma. It cannot cut interest rates aggressively to support activity without stoking the inflationary fires, yet if it tightens policy to fight inflation it could exacerbate the growth slowdown. This policy tug-of-war may well contribute to market volatility and the likelihood of a correction. Equity investors, who have been enjoying the Goldilocks scenario of decent growth and falling inflation, could suddenly find themselves in a more tenuous environment – one where earnings forecasts get trimmed even as interest rates stay relatively high.
Already there are hints of this tension: yields on longer-term Treasuries have climbed off their lows in recent weeks, reflecting concerns that inflation might prove stickier and force the Fed’s hand. Moreover, political uncertainty remains elevated in other areas, from budget negotiations to foreign policy brinkmanship, and these add an extra risk premium to markets. We’ve seen how surprises – a tough tariff talk, a government shutdown scare, a geopolitical shock – can quickly send stocks falling. After such a prolonged rally, valuations are stretched (the S&P 500 is trading around 22 times forward earnings, well above historical norms), so the margin for error is thin. In our view, it would not take much – a couple of disappointing economic reports or a jump in inflation data – to trigger a healthy pullback in asset prices in the medium term. The groundwork is in place for a correction to materialize, even if the exact timing is uncertain.
Importantly, we do not see any such correction as the start of a prolonged downturn. Rather, any slowdown is likely to be brief and transitory, thanks to the extraordinary pro-growth policies still in the pipeline. The fiscal taps, as noted, are wide open – and not just from that one summer spending bill. There is talk in Washington of additional tax cuts on the horizon, potentially “trillions more in tax cuts” alongside substantial deregulation efforts. The current administration has made it clear that it views low taxes, light regulation, and certain strategic industrial investments (like re-shoring critical supply chains) as keys to long-term prosperity.
Indeed, if we consider the cumulative effect of recent and proposed policies, the net impact is a “durable positive shock to growth” in the U.S. economy. This means that even if we hit a soft patch – say a technical recession by the traditional definition – the policy response and underlying stimulus could quickly reignite activity. We’re already seeing early evidence that the private sector’s setbacks can be cushioned by public policy. For example, despite the manufacturing slump and higher borrowing costs, household consumption has been steadied by fiscal support and prior savings buffers. Many American households refinanced into ultra-low fixed-rate mortgages during the pandemic boom, and those fixed payments insulate them now from the Fed’s rate hikes. Consumers also accumulated savings in the pandemic years, and although much of that excess is being spent down, it continues to provide a cushion. As a result, consumer spending – which makes up about 70% of GDP – has not collapsed under the weight of higher prices or borrowing costs. In fact, it’s been surprisingly resilient, with retail sales and service sector activity ticking along decently. This resilience, bolstered by the government’s fiscal largesse, should help mitigate the depth of any growth scare.
Even business investment, which we noted may falter due to uncertainty, could get a second wind once firms see the concrete effects of deregulatory measures. Sectors like energy, finance, and healthcare are already benefiting from executive orders and legislative changes that roll back certain regulations, streamline permitting, or otherwise reduce the cost of doing business. The Administration’s explicit aim has been to “unleash growth” by removing what it deems unnecessary red tape, and while critics argue about environmental or social costs, there’s no denying the short-term economic boost of such moves.
All told, the policy mix suggests that any recession would be shallow and short-lived. One research framework even posits that although a technical recession could occur due to the tariff shock and uncertainty, the probability of a severe, prolonged recession remains low given the powerful offsetting fiscal and regulatory stimulus. This implies a quick recovery – a “pause that refreshes” – rather than a prolonged decline. Investors who pull back in a panic risk missing the subsequent rally once the stimulus kicks in and confidence returns. Our strategy, therefore, is to treat any medium-term dip as an opportunity rather than a threat, so long as the policy spigots stay open.
No discussion of the U.S. outlook would be complete without considering the international dimension – and here lies a cautionary tale. Years of hefty U.S. budget deficits and trade imbalances have left America heavily reliant on foreign capital, and there are signs that foreign investors’ enthusiasm for U.S. assets is waning.
The U.S. now carries a net international investment position (NIIP) deficit of roughly three-quarters of GDP, meaning our nation owes dramatically more to the rest of the world than the rest of the world owes to us. In dollar terms, that’s a net debtor position on the order of $25 trillion. This didn’t happen overnight; it’s the cumulative result of persistent current account deficits (imports and capital outflows exceeding exports) financed by selling U.S. assets to overseas buyers year after year. For a long time, foreign creditors were more than happy to park their money in the U.S., viewing Treasury bonds, stocks, and real estate here as safe and rewarding investments. But recent shifts suggest a growing skepticism among our foreign lenders.
One glaring metric is the share of U.S. government debt owned by foreigners. A decade ago, overseas investors held about half of all marketable Treasury securities. Today that share has fallen to roughly one-third, and it’s been declining steadily. It’s not that foreigners are dumping Treasuries en masse – there’s been no catastrophic “rush for the exits” – but rather they’re buying less eagerly than before, even as the U.S. issues ever-more debt. In effect, a slow-motion foreign “buyer’s strike” could be underway. Part of the issue is performance: as we noted, foreign stock markets have outpaced the U.S. this year, and a weakening U.S. dollar has enhanced those foreign returns for international investors. Capital tends to chase the best returns.
With the U.S. dollar index falling over 10% in the first half of 2025 – its worst start in decades– global investors are logically looking to places like Europe, Japan, or emerging markets where the growth-policy tradeoff is more favorable and currency trends are in their favor. But beyond pure returns, the behavior of foreign investors is also influenced by trust and predictability, and this is where U.S. policy uncertainties take a toll. America’s allies and creditors have watched, sometimes in astonishment, as Washington careens from one fiscal standoff to the next, or abruptly changes trade and foreign policy posture. The “America First” ethos – tariffs, renegotiated trade deals, unpredictable diplomatic moves – may or may not yield desired concessions from trading partners, but it undeniably introduces doubt. The often erratic policies of the U.S. administration have upset longstanding norms and left investors questioning whether Washington remains a reliable steward of the global financial system. That loss of confidence is subtle but crucial. It means that the rest of the world might not be so willing to continue extending the U.S. the benefit of the doubt (and the benefit of their savings).
Already we’ve seen major foreign holders of Treasuries like China and Japan reduce their exposure. Geopolitical tensions – for instance, U.S. sanctions and great-power rivalry – have spurred some countries to diversify reserves away from the dollar. If these trends intensify, the U.S. could find itself in a difficult position: needing to finance “twin deficits” that currently sum to roughly 12% of GDP without as much willing foreign capital. In such a case, either interest rates would have to rise to attract buyers, or domestic investors (possibly including the Fed) would have to absorb more of the load. Neither scenario is particularly comforting. Higher Treasury yields could crowd out domestic investment and prick the asset price buoyancy we described, while an increased role for the Fed in financing deficits starts to blur the line between independent monetary policy and debt monetization.
This brings us to the long-term consequences of the current policy mix. Put simply, the U.S. is charting a course that likely ends in elevated inflation and financial repression. “Financial repression” may sound ominous, but it’s a playbook with ample historical precedent. It refers to the array of policies that keep interest rates artificially low relative to inflation, thereby slowly eroding the real value of debt. After World War II, for instance, many advanced economies (the U.S. included) used a combination of caps on interest rates, central bank bond-buying, capital controls, and steady inflation to whittle down huge debt loads. We appear headed down a similar path. High public debt, persistent deficits, and hesitant foreign funding create an environment where the easiest way out is to let inflation run slightly hot and pin down nominal rates.
Indeed, macroeconomic strategists are increasingly expecting just that outcome. Some foresee a policy regime in which, over the next few years, interest rate cuts become heavily politicized and the Fed is pressured to maintain a “durably negative” real Fed funds rate – possibly even resorting to formal yield curve control by the later 2020s. In other words, if bond markets won’t willingly finance U.S. deficits at low rates, the central bank may step in as a buyer of last resort to cap yields, even if inflation is above target. Already, the groundwork is being laid. The Fed’s leadership is being reshaped, with appointments seen as more aligned to the administration’s growth-oriented, weak-dollar preferences. There’s open discussion in policy circles about tweaking bank regulations (like leverage ratios) to encourage banks to hold more Treasuries – a subtle form of pressure that channels private capital into funding government debt. These moves, taken together, point toward an implicit policy of gradually debasing the currency to manage the debt. To be clear, this doesn’t suggest runaway 1970s-style inflation; rather, it implies inflation settling modestly above the Fed’s 2% target – say in the 3-4% range – for an extended period, while nominal interest rates are kept a bit lower than that. The result is negative real yields, year in and year out. Over time, those negative real rates quietly shave off a few percentage points of the debt burden (as a share of GDP) each year.
The losers in this scenario are holders of cash and bonds who earn returns that don’t keep up with inflation – effectively paying a hidden “tax” that helps retire the debt. The winners, or at least the survivors, are leveraged entities like governments (and homeowners) whose liabilities become easier to service in inflated-away dollars. We are already seeing early signs of this regime. Core inflation, while down from its peak, remains sticky above 2%, and the Fed has signaled greater tolerance for “average” inflation outcomes – effectively letting inflation run higher for longer. Meanwhile, even with recent rate hikes, real interest rates have been below zero for much of this cycle, and markets believe any future Fed easing will again put rates behind the inflation curve. It is financial repression in all but name.
Such an environment has profound implications for investors: it argues for assets that can outpace inflation (equities, real estate, commodities, gold) and caution on fixed income unless yields adjust upward significantly. It also means volatility, as the anchor of a 2% inflation target is no longer firm. Policy may oscillate between tightening and easing, trying to manage that fine line of not letting inflation explode, but also not choking off growth – all while stealthily chipping away at the debt via negative real yields.
In summary, we envision a U.S. economy and market that are balancing on a three-part timeline. In the immediate term, the party continues: growth is humming along, markets are strong, and policy is unequivocally supportive. We remain overweight equities and other risk assets to capture this momentum, cognizant that the fiscal and monetary tailwinds can carry us a while longer. As we transition to the medium term, we grow more vigilant. The sugar rush of stimulus will eventually collide with the reality of trade frictions, rising costs, and wavering business confidence. A market correction or even a brief recession would not surprise us in that interim. However – and this is crucial – we would view that downturn as an opportunity, not a threat, because the bigger narrative is one of an indomitable policy push to reflate and restart the cycle. Thus, for the subsequent rebound, we are positioned to lean into quality equities (particularly those abroad, which stand to benefit from America’s overextended finances via a weaker dollar) and real assets that flourish in reflation. Finally, looking at the long run, we are preparing for an environment of financial repression and higher baseline inflation. That means staying mindful of duration risk in bonds, maintaining exposure to inflation hedges like gold (which has already proven its mettle this year), and favoring assets tied to real economic growth over paper promises. The big picture is that the U.S. is choosing the path of growth and inflation over austerity. Markets can thrive in such an environment, especially initially – think of equities in the 1950s under negative real rates, or more recently, the asset price boom of the 2010s with ultra-low yields. But it requires a keen eye on the exit strategy. We must be ready to adjust when the music eventually slows or stops. For now, though, the music is playing loudly. We advise our clients to stay engaged but watchful: enjoy the tailwinds of a strong market, remain invested in the opportunities both at home and abroad, but keep that umbrella handy for the rain clouds gathering on the horizon. If you are not yet a client of Euro Pacific Asset Management, please reach out to an advisor today to learn how we can help you to navigate these markets in the years to come.
A message from Advisor Perspectives and VettaFi: Ready for your next career move?Explore our articles on financial advisor transitions.
© Euro Pacific Capital
Read more commentaries by Euro Pacific Capital
