As markets rally, celebrating the reduction of the previously expected economic shock from high tariffs, there is another threat that is materializing that few investors are adequately paying attention to: A fiscal policy shock.
As I will explain in this article, and in even greater detail in the video attached at the bottom of the article, the US economy is facing a substantial “drag” from fiscal policy that could potentially push the US economy into recession by late 2025.
The Underlying Problem: A Record Deficit at Full Employment
At the end of Q1 2025, the U.S. federal budget deficit had widened to 7.0% of on an annualized basis—an unprecedented level for a peacetime and full-employment environment. Virtually all economic analysts agree that this imbalance is fundamentally unsustainable.
Addressing the fiscal deficit would entail a significant cost in terms of short-term economic growth, and this is a lesson that US markets may learn the hard way in 2025.
Through a mix of legislative policy inertia, executive actions, and new legislative initiatives, a major fiscal shock to the economy is potentially brewing.
Understanding the Inertial Effects of the Status Quo
Even without new policy interventions, the US economy is already subject to a significant fiscal headwind. According to the Hutchins Center’s Fiscal Impact Measure, the slowdown in deficit growth (relative to nominal GDP) would have reduced GDP growth by 0.63 percentage points in Q1 2025. This trend is expected to accelerate, with drag estimates reaching -1.4% by Q2.
It is important to understand that this does not imply that the deficit is expected to shrink in terms. It merely means that deficit growth is expected to lag the growth in other drivers of nominal GDP. This results in a downward “drag” on the growth of overall economic activity.
Executive Austerity: Cuts and Tariffs
Beyond the inertial effects described above, which are mostly a carry-over from budgets approved by the prior Congress and signed into law by the previous President, executive actions under President Trump have already introduced additional fiscal tightening. These include:
- Spending Reductions via DOGE: The Department of Government Efficiency (DOGE) has implemented spending cuts across various agencies. Programs such as USAID have been defunded or restructured. A voluntary early retirement scheme for government employees has seen substantial uptake. Wasteful spending has been identified for cuts in virtually every major department of the Federal Government. Despite the fact that DOGE is currently claiming $170 billion in estimated savings, we are conservatively projecting cuts in the range of $100 billion (annualized) for the remainder of 2025.
- Tariff Increases: A sweeping 10% universal tariff on imports, alongside targeted tariffs for strategic sectors and certain reciprocal tariffs are expected to generate approximately $200 billion in annual revenue. While this boosts fiscal balances, it also dampens US domestic demand and international demand for US products.
Together, these measures represent a combined fiscal tightening of about $300 billion (annualized) —or—effectively shrinking the US budget deficit by roughly 15% on an annualized basis.
FY 2026 Budget and Front-Loaded Pain
Though most congressionally approved budget changes won’t take effect until the start of fiscal year 2026 (October 2025), the administration’s current “Skinny Budget” outlines deep discretionary spending cuts. Non-defense agencies—such as the EPA, Education, HUD, and international aid programs—are targeted for reductions expected to generate $163 billion in savings.
Defense and homeland security budgets will see corresponding increases in spending. However, we believe that the cuts will be front-loaded in 2025, relative to the spending increases, which will be back-end loaded in order to boost the economy at the time of congressional mid-term elections.
Tax relief is expected to be approved in the FY 2026 budget, but this will not impact the economy until April 2026. By contrast, the full brunt of tariff increases will be felt during 2025. Furthermore, increased taxes on university endowments and non-profits, although not payable until 2026, are likely to have an adverse impact on their spending budgets in 2025.
Can Offsetting Growth Drivers Compensate?
Some have argued that personal consumption, business investment, or trade could offset the fiscal shock. But the evidence is not encouraging.
- Consumer Spending: slowed in Q1 2025, and consumer sentiment indicators (e.g., University of Michigan’s Index) show extreme consumer unease.
- Investment: The outlook for investment is mixed. First, investment in equipment was likely front-loaded in Q1 to avoid tariffs, a phenomenon that will cause equipment investment demand for the remainder of the year to be relatively weak. Second, residential investment is languishing under the weight of high mortgage rates and oversupply. A potential bright spot might be found in the highly publicized announcements by several corporations and foreign entities to make large investments in the U.S. However, we are skeptical that these non-binding and politically motivated commitments will cause a significant surge in US investment during 2025.
- Trade: Tariffs may reduce imports, which technically boosts GDP. However, this has a negative impact on domestic economic activity that is linked to those imports (transport, warehousing, marketing, and sales). Furthermore, higher global tariffs will result in reduced global demand for U.S. goods.
The Recession Risk Is Real
Putting the pieces together, we estimate the total fiscal drag for the remainder of 2025 will be approximately 3.3% of GDP on an annualized basis. This includes:
- A -1.3% drag from inertial fiscal drag due to decelerating deficit growth.
- A -2.0% contribution from front-loaded austerity (spending cuts and tariffs).
In a full-employment economy with a potential growth rate of 2.0%, this level of fiscal contraction is severe and could induce a recession. Unless consumption, investment or exports significantly overperform—and there’s no reason to believe they will—a recession seems likely, even if only a mild one.
Market Implications
Equity markets have thus far priced in optimism regarding economic growth and associated corporate earnings growth. Valuations, particularly among large-cap tech firms such as the “Magnificent 7” are predicated on expectations of strong earnings growth. However, if the US experiences a business cycle recession, these growth expectations will be disappointed.
Due to extremely high valuations, driven by expectations of exceptional earnings growth, US equity indices like the and are vulnerable to substantial declines, if the US economy experiences the sort of fiscal shock described in this article. In the event of a business cycle recession, we expect US equities to fall below recent lows and into bear market territory.
Final Thoughts
The combined effects of executive spending cuts, tariff-driven revenue increases, and front-loaded legislative austerity measures would constitute a substantial fiscal austerity shock to the US economy. Precisely because few analysts see this shock coming, it could present opportunities for active strategic investors. This is discussed in greater detail in this video: