Insights

We've previously spoken about the problem of the US budget deficit, and we've also discussed how the increasing size of the deficit is forcing up the level of debt year after year. Now, we're going to revisit this issue and then look into what Elon Musk and Vivek Ramaswamy are attempting to do about it through their Department of Government Efficiency, or DOGE.

Up until about 2019, things were fairly stable in terms of the US budget. However, at the beginning of the pandemic, the US budget deficit exploded from 5% of US GDP in 2019 to just under 14% of GDP in 2020. It peaked at 13.94% in that year. The level of debt in the US, which was around 80% of GDP, began to rise. By 2020, the deficit was 13.94% of GDP, and though it slowed a little in 2022 to just under 4% of GDP, it grew again to 7.1% of GDP in 2023, and is projected to be 7.6% of GDP in 2024.

The problem isn't just these current deficits; it's that there are continuing deficits built into the legislation. These deficits are expected to continue: 7.3% in 2025, 6.7% in 2026, 6.2% in 2027, 6.2% in 2028, and 6% in 2029.

Looking at the level of US debt, it was stable at around 80% of GDP from 2012 to 2018. However, the expansion of budget deficits caused the level of debt to GDP to rise. This rising level of debt to GDP was something that Jay Powell referred to at the last Federal Reserve meeting as unsustainable. The International Monetary Fund tell us that net debt to GDP in the US rose from 83% in 2019 to 97% in 2020, when the deficit hit 14% of GDP. It then stabilised at 97% of GDP, slightly declining to 93% in 2022.

However, with continuing forward deficits, US debt to GDP is projected to rise dramatically. By 2025, it is expected to hit 98% of GDP, 101.7% in 2026, 104% in 2027, 105.8% in 2028, and 109% by 2029. This steady rise in debt as a percentage of GDP is what makes the debt unsustainable.

In recent weeks, two individuals have come forward with an initiative to reduce the US budget deficit, as part of the Trump administration’s efforts. Elon Musk and Vivek Ramaswamy have released a full statement outlining their plans. Their goal is to generate reductions in the number of people working in the US government, thereby reducing the size of the deficit that finances these positions. As the deficit falls, they hope it will also stabilise the US economy.

Musk and Ramaswamy have made it clear that they will not be employed by the government and will work without pay. They state they will serve as outside volunteers, not federal officials or employees. Unlike typical government commissions or advisory committees, they won’t just write reports or cut ribbons; they intend to cut costs. They are assisting the Trump transition team in identifying and hiring a lean team of small-government advocates, including some of the sharpest technical and legal minds in America. This team will work closely with the White House Office of Management and Budget.

They say that they aim to advise the Department of Government Efficiency on three key types of reform: regulatory rescissions (reducing regulations), administrative reductions, and cost savings. By reducing regulations, they argue, the number of employees required to enforce them will also be reduced, which in turn will lower government spending and lower the budget deficit. As regulations are cut, fewer employees will be needed, and as those employees retire or leave, federal spending will decline, which should reduce the size of the budget deficit.

Musk and Ramaswamy’s plan also focuses on driving change through executive action, based on existing legislation, rather than through new laws. They propose presenting a list of regulations to President Trump for executive action, which would immediately pause the enforcement of these regulations and begin the process of reviewing and rescinding them. They believe that removing such regulations will liberate individuals and businesses from burdensome rules never passed by Congress. This will stimulate the economy.

They further argue that the reduction of federal regulations will logically lead to mass headcount reductions across the federal bureaucracy. The Department of Government Efficiency (DOGE) plans to work with appointed officials in various agencies to identify the minimum number of employees necessary for agencies to perform their constitutionally permissible and statutorily mandated functions. The number of federal employees to be cut will be proportional to the regulations nullified. Fewer employees will be needed to enforce fewer regulations, and once the scope of authority is properly limited, the agencies will produce fewer regulations. This will result in further reductions in both personnel and spending.

Additionally, the DOGE aims to reduce federal overspending by targeting the $535 billion in annual federal expenditures that are unauthorised by Congress. These are funds spent by the administrative state on items like public broadcasting, grants to international organisations, and progressive groups like Planned Parenthood. Removing such spending is seen as another way to curb the budget deficit.

Their plan will focus on eliminating unnecessary regulations and the employees who enforce them, ultimately aiming to reduce the size of the Federal Government and its budget deficit. Their report on these efforts is expected to be completed by 4 July 2026, the 250th anniversary of the Declaration of Independence, marking the start of a national celebration of that milestone.

The process I follow begins with reviewing the outlook from the International Monetary Fund (IMF), then I run my models, and currently, I'm at the beginning of that process. I thought I'd share the IMF's base case outlook and where I might adjust it based on my models. I believe these nuances are important.

What is immediately clear when you examine the complete outlook is that there is no recession on the horizon. The US is experiencing growth at 2.2%.

Following a difficult period in the Euro area, despite a miserable past, recovery is underway with modest growth expected at 1.1% in 2024 and 1.6% in 2025. As for China, the IMF estimates growth at 4.8% this year, but I think it will be closer to 4.6%, with a slight recovery to 4.5% next year. However, I think 4.3% is more likely next year, primarily due to ongoing weak demand in the Chinese economy. That said, these are still excellent figures, especially considering the size of the Chinese economy, which is growing at a pace four times faster than Germany’s and nearly twice as fast as the US.

The standout performer in recent years has been India. It grew by 8.2% last year and 7% this year, with projections ranging from 6.5% to 7% next year. India's high growth is set to continue for the next two decades, driven by a rising working-age population. This is unlike China, where the working age population is shrinking.

In Australia, growth has been relatively soft this year, hovering around 1.2%, largely due to the decline from a record high commodities boom. The IMF forecasts 2.1% growth next year, but I think it will be closer to 2.5%. Still, this is modest growth compared to Australia's historical standards. On the inflation front, most places are experiencing low and falling inflation, except for Australia. The US's headline CPI is projected to decrease from 2.3% this year to 2% in 2025. The Euro Area is also seeing a slight reduction, from 2.4% this year to 2.2% next year. In China, inflation is low, with deflation last year and a forecast of around 0.9% to 1% this year, due to weak consumer demand. Usually, inflation in China is about 2%, and it should gradually increase as the economy recovers.

In India, inflation is targeted at 4%, and they are on track to meet that goal this year and next. In Australia, inflation this year could be around 2.7%, slightly lower than the 3% the IMF expects, with a slight increase to around 3.7% next year.

Overall, what we see is that the global economy is returning to reasonable growth. The fear of a recession has subsided, and the outlook is positive across most regions. Growth in the US is likely to exceed the Federal Reserve's estimate of 2%, with some models forecasting around 2.2%.

Thanks to the recovery in the Euro Area, India's strong performance, and Australia's rebound, the global outlook remains strong.

Still, it is possible that the market has already priced this in.

Last week, during a press conference following the Federal Reserve's decision to cut rates by 25 basis points, something we had forecast, J. Powell was asked about the US government debt. He stated that while the current level of US government debt is sustainable, the trajectory of that debt is not. This comment has sparked a discussion on how the Trump presidency, with its emphasis on cutting corporate taxes, will impact the US budget deficit.

Looking ahead, the US budget deficit for 2026 will be drafted in 2025 when both the presidency and Congress — the Senate and the House of Representatives — are all under Republican control. Interestingly, the Speaker of the House, Mike Johnson, who is part of the conservative Freedom Caucus, has made it clear that he wants to reduce the size of the US budget deficit. This will be a key issue moving forward.

The US budget deficit has been a frequent topic of conversation because it can serve as an indicator of trends in the commodity cycle. For instance, the most recent low in the deficit occurred in 2022, at 3.9% of GDP, signalling the bottom of the cycle for commodities. However, the budget deficit rose to 7.6% of GDP in 2023, and for the current year, it is expected to peak at 7.63% of GDP. This suggests that the peak in commodity prices may occur around 2026.

A significant part of the discussion centres on President Trump's promise to reduce US corporate tax rates to 15%. This is the same corporate tax rate as Germany. The potential cost of this tax cut is substantial, with estimates ranging from $460 billion to $673 billion. For the sake of discussion, if we assume the cost is around $500 billion, the impact on the US budget deficit will be significant. Currently, the US deficit is estimated to be $2.2 trillion, or 7.3% of GDP, and projections for next year remain the same.

Sustainability in terms of the US budget deficit is generally considered to be a level that matches GDP growth. Given that US GDP growth is expected to be around 2%, the deficit could realistically be about $600 billion, much lower than the current $2.2 trillion. This creates a significant challenge for policymakers, especially since cutting spending will likely be the key to reducing the deficit.

Mike Johnson, as part of the Freedom Caucus, will push for cuts in government spending, and President Trump has appointed Elon Musk to assist in finding opportunities to streamline government expenses. Musk, who is known for his ability to cut costs in companies like Tesla and X (formerly Twitter), will look for inefficiencies in government spending, even though the "Department of Government Efficiency" he is heading will exist only as an advisory body. Nevertheless, Musk’s skill and reputation for cost-cutting could play a crucial role in helping to bring down the deficit.

The push to reduce the budget deficit while implementing tax cuts will be a central focus in the lead-up to the 2026 US budget. The proposed corporate tax cuts to 15% will add roughly $500 billion to the deficit, but they are expected to increase after-tax corporate earnings, which should drive stock prices higher. This contrasts with the Democrats' proposal to increase corporate taxes, which would likely lead to a sell-off in the stock market and a potential recession in the following year.

If the Republican-led government can successfully reduce the budget deficit while implementing corporate tax cuts, it could be a significant boost to both the US economy and the stock market in 2026.

Well, I’ve spoken before about the Reserve Bank of Australia and the Federal Reserve. The easiest way to understand what central banks are doing is to look at employment growth. When employment growth is higher than the long-term median, central banks tend to either hold rates where they are or to tighten. When employment growth is lower than the long-term median, central banks tend to cut rates.

So, today we’ll look at where things are and explain what’s been happening this week and why the Reserve Bank of Australia held rates where they were, and why the Fed cut rates by 25 basis points. In the first slide, what you see is the rate of growth of employment in Australia. The long-term median is 2.3%, but the current rate of employment growth is 2.97%. So, it’s above the long-term median, and that’s strong. This is largely due to support from the federal government employing people in the public sector. But as the Deputy Governor of the Reserve Bank says, these are still real jobs. For that reason, the RBA is holding rates steady until inflation falls or unemployment rises. This means that if unemployment rises, we can expect inflation to fall in the future.

The Federal Reserve, on the other hand, has a different story. When we look at the rate of growth of employment in the US, the level of actual employment year-on-year is 1.3%. Employment growth has been slowing as we go through the year, and that’s lower than the long-term median of 1.6%. At the previous meeting, the Fed cut by 50 basis points. I had forecast at that time that it would continue cutting rates in November and December, and we just saw a 25 basis point cut today. At the Fed Reserve press conference after the Fed statement was released, Jay Powell said that geopolitical risks to the US economy are elevated. Still, he said that when we look at the US economy, it is still very sound, with strong growth, a strong labour market, and inflation coming down.

When he was asked about the US national debt, Powell said the national debt is not unsustainable, but the path of the growth of that debt is. In other words, the size of the US deficit is too large.   If the growth in US Debt continues, Powell warned, it will ultimately be a threat to the economy.

Since the election of Donald Trump, we’ve seen that there is a significant number of supporters in the House of Representatives of proposals to cut spending. Also, suggestions for cuts could come from figures like Elon Musk, while Robert F. Kennedy Jr. has advocated closing whole sections of the Food and Drug Administration. These budgetary savings could help reduce the size of the budget deficit, but we’ll have to wait and see how it plays out.

Powell currently holds his appointment until May 2026.  He was asked twice during the press conference whether he would resign. He replied with a simple "no" when asked if he would resign if President Trump asked him to resign. When asked again if he or other board members could be fired by the President, he said, "No, it is not permitted by law." So, unless Powell is impeached by both houses of Congress—which is incredibly unlikely—he will certainly serve his term through 2026.

When a reporter asked Powell about the neutral rate, or the natural rate of interest, he said that it’s difficult to pinpoint. The natural rate was defined in the 19th century by Swedish economist Knut Wicksell. Powell acknowledged that we’ll eventually know the neutral rate “by its works”. Based on our models, we believe the neutral Fed funds rate is 3.85% right now, considering where US employment, inflation, and inflation expectations stand in the US. We think the Fed funds rate will continue to fall until it reaches that level of 3.85%.

As I predicted, the Fed cut rates by 25 basis points in November, bringing the effective funds rate down to 4.6%. We believe there will be another rate cut in December, bringing the effective Fed funds rate to 4.35%, which will be equal to the Australian cash rate.

We don’t think rates will stop there. We expect another rate cut on January 28th, bringing the Fed funds rate to 4.1%. Following that, there will be a Fed meeting on Saint Patrick’s Day, where we expect another rate cut, bringing the Fed Funds rate to 3.85% This is where our model suggests the neutral Fed funds rate should be.

Any changes to that forecast will depend on the direction of inflation, unemployment, and inflation expectations in the US. If inflation goes down, unemployment rises, or inflation expectations decrease, rates could be cut further.

Still for now, we think the bottom of the Fed funds rate will be 3.85% by March next year.

Interestingly, the Fed is not just cutting rates; it’s also doing quantitative tightening at a rate of $25 billion per month. That means the size of the Fed’s balance sheet is falling by $25 billion each month.

However, at that rate, it will take nearly 10 years for the Fed’s balance sheet to fall back to the $4 trillion it was at in 2019. So, while the Fed may continue cutting rates next year, quantitative tightening is likely to continue for many years to come.

A roadmap of possible US election outcomes and their context versus market fundamentals.

Key points:

• A benign US election process with a quick and clean result would be the least disruptive outcome for capital market but this appears to be a relatively low probably scenario.
• Given that parts of the market look abnormally stretched, we think it’s prudent that investors should have a plan should market uncertainty and/or volatility escalate.

History shows that US equities in the very short term tend to trade flat into elections but then rally out the other side as investors have more certainty on forward policy and leadership. US equity markets appear to be in a mood to do the same in 2024, with typical seasonal strength into Christmas likely to become the market narrative should the election go smoothly. However, the current circumstances look less than typical.

History shows that US equities in the very short term tend to trade flat into elections but then rally out the other side as investors have more certainty on forward policy and leadership. US equity markets appear to be in a mood to do the same in 2024, with typical seasonal strength into Christmas likely to become the market narrative should the election go smoothly. However, the current circumstances look less than typical.

First let’s consider what a win might look like on either side. There is a mountain of opinion about what election outcomes might mean for the US. The reality is that no matter who becomes President, investors will face ongoing uncertainties about policies which have potential to mould the US economy. Should Harris prevail, it looks unlikely the Democrats would control the US senate, making the passage of reformative legislation more difficult. The “status quo” might actually be the most benign outcome. Should Trump prevail, there is greater uncertainty about whether pre-election policy rhetoric – particularly on high potential impact policies around trade tariffs – are actually enacted.

At this point it does look like the policies of both parties though would entail more Government spending than capital markets currently expect. This could re-assert upward pressure on US inflation and might mean that the pace of US rate cuts could be slower than markets currently hope.

It’s quite notable that the pricing of US Treasuries have reflected this very potential in recent weeks, with yields trending higher. It’s equally notable that equity market behaviour looks to be in disagreement with bonds, arguably disregarding risks around the US rates trajectory. Other market valuation metrics also look somewhat dislocated.

US credit spreads have narrowed to levels not seen since June 2007. This decline mirrors the strength in equities but also reflects expensive valuations and can indicate some complacency in the market's assessment of credit risk. Absolute US equity valuations are at decade highs. Equity valuations relative to bonds as measured by the equity risk premium look the most stretched, with the ERP at multi-decade lows below 1%. Stretched valuations does increase the market’s vulnerability to unforeseen events or uncertainty.

It's prudent to be prepared

The US is among the biggest success stories in the global economy. To achieve disinflation without much disruption to growth or employment is no mean feat. US corporate earnings have also been strong and resilient, projecting compound growth of 12-15%, which is really important here. However, several measures of capital market strength are looking stretched and/or abnormal with the disagreement reflected in bond yields the most notable. Getting US elections out of the way is typically good for markets. However, several various potential scenarios around the election could easily lift uncertainty and spike market volatility at current levels. Confirmation of the election process itself could include material delay, challenge, dispute and/or unrest. We think investors should prepare accordingly.

Domestic stocks, themes and opportunities that we have recently be advocating for investors include: trimming banks exposure, rotating exposure into resources (BHP & RIO), value in energy (Woodside), US rates leverage via James Hardie and opportunities in stocks on weakness in Lovisa and Eagers Automotive.

International stocks currently on the Morgans US focus list include Meta Platforms, Nike, Coca Cola, Starbucks, Honeywell and Berkshire Hathaway.

Morgans clients receive exclusive insights such as access to the latest stock and sector coverage featured in the Month Ahead. Contact us today to begin your journey with Morgans.

Jensen Huang, the rockstar CEO of NVIDIA, recently described Artificial Intelligence (AI) as ‘the most transformative technology of the 21st Century’ which ‘will affect every industry and aspect of our lives’. The CEO of Alphabet, Sundar Pichai, went further, saying AI is ‘probably the most important thing humanity has ever worked on’. Amid all this hyperbole, it can be daunting to know where to start as an investor looking to get exposure to AI. We offer one framework for thinking about this in the Month Ahead for November. We recommend investors start making sense of AI by considering stock opportunities in these three distinct areas:

Artificial Intelligence Providers

It is no coincidence that the world’s leading Cloud Service Providers (Microsoft, Amazon, and Google) are leading the race to commercialise Artificial Intelligence and Large Language Models (LLMs), alongside that technological shapeshifter Meta Platforms. These companies are also known as ‘Hyperscalers’ due to their technical expertise in operating computing infrastructure at levels of complexity that would make your head spin.

The Hyperscalers are typically well funded and cash generative. Their ‘ownership’ of business and personal data puts them at the forefront of building, training, and ultimately monetising LLMs. Collectively, these companies are expected to spend a staggering US$700bn in capex over the next three years, the bulk of which relates to AI.

In many ways, Microsoft (NASDAQ: MSFT) is the most uniquely positioned. As the key supplier of business productivity tools in the world, it has the vast technical expertise, data and customer base best suited to benefit from the rise of AI. As more and more businesses embrace AI we expect they will embrace Microsoft’s AI offering and both parties should benefit. Microsoft reported its September quarterly result on Wednesday and indicated Microsoft AI is on track to be its fastest ever product to reach $10bn in annual recurring revenue (less than three years).

Digital Infrastructure

Digital infrastructure companies power the data centres, cloud computing and research activities that are integral to the digital ecosystem and the rise of AI. Internationally the best-known name in the space is AI chip supplier NVIDIA, which is widely held to be best in class and a unique value proposition.

Enjoying all the benefits of the AI growth opportunity with less volatility are the operators of data centres. Data centres are facilities that store, process, and manage the vast amounts of data foundational to AI, ensuring secure and efficient data flow, backup, and recovery. The largest operators in the world are Digital Realty and Equinix. Digital Realty recently reported a record sales quarter during which it sold double the data centre capacity of its previous high and about four times more capacity than it usually sells in a quarter. This reinforces our view that the significant demand for cloud computing and AI-related digital infrastructure is going to unpin attractive returns and long-term growth.

Here in Australia, the data centre space gathered recent attention following the recent $23bn purchase of private data centre operator AirTrunk. In the listed arena, NEXTDC and Goodman Group are the largest data centre operators on the ASX. Our preferred exposure is NEXTDC (ASX: NXT). It has 17 operational data centres in Australia and nearly a dozen under construction or about to be built across Australasia and Asia.

Data Networks

AI needs a combination of technical expertise, computing power, data centre space and data. An extremely large amount of data is needed to train an AI agent or LLM. Once the training is complete the AI agent also needs to be given regular up-to-date data in order to remain relevant and useful. This is where traditional data networks (such as telcos like Telstra, TPG Telecom, Superloop and Megaport) come into play.

Traditional telecommunications companies will benefit from the astronomical growth of data around AI. Telstra for instance is building a specialist inter-capital network with a A$1.5bn capital budget to fund this project. However, our preferred exposure is through the more specialised and capital-light Megaport (ASX: MP1). Megaport is a global cloud connection network and the leading Network as a Service provider. It operates the largest data centre connection business in the world, connecting to 850 data centres through a fully automated, on-demand telco network. We think it is uniquely placed to help business move data globally and benefit from the growth of data related to both cloud computing and AI.

Morgans clients receive exclusive insights such as access to the latest stock and sector coverage featured in the Month Ahead. Contact us today to begin your journey with Morgans.