Asset Inflation’s Debt

Photo: Generated with ChatGPT.

Foreboding. Asset markets are inflating as the artificial intelligence (AI) frenzy steams forward to an uncertain destination. From the railway barons to the titans of tech, markets have plowed capital into land grabs when technology introduces new markets. While valuations are not as frothy as prior frenzies, the financial environment is different. Increasing tariffs are a form of consumption tax that consumers will pay, resulting in slower growth. The balance sheet of the lender of last resort is inflated due to prior rescues, and the fiscal deficit is historically high, except during recessions. The result is an economy leveraged beyond its natural rate. If technology fails to deliver the promised return promptly and inflation persists as tariffs take effect, the economy may not receive the necessary support from fiscal policy. Indeed, this time is different.

A trade war predicated on tariffs and the reshoring of industrial capacity is inconsistent with operational efficiency and the political objective of expanding US exports. Profit margins will bear the burden.

Risk On. While investors may detest uncertainty, volatile trade policy is not deterring them. Equities rose materially across all segments in the last quarter, while only commodities declined as the US dollar weakened (Exhibit 1). Indeed, the TACO trade is alive and well.[1] Yet, the confidence of markets while a mercurial trade policy persists, let alone the impact on prices and growth, seems less than coherent. The most credible question is, when will investors realize the economic weakness beneath them?

From the railway barons of the 19th century to today's tech titans, markets have consistently funnelled capital into speculative land grabs when revolutionary technology emerges. In recent years, the emergence of generative AI and machine learning has accelerated this trend. Corporations, venture capital firms, and public equity investors are investing heavily in AI platforms, chipmakers, and infrastructure. The surge in AI enthusiasm is driving elevated valuations for both the tech sector and broader markets.

Exhibit 1. Asset Class Returns (Second Quarter 2025)

Source: IEX Cloud. CRM Calculations. Total returns from March 31, 2025, to June 30, 2025.

Financing Wealth. Across time, markets have consistently funneled capital into speculative land grabs when revolutionary technology emerges. In recent years, generative AI and machine learning have followed that pattern. Corporations, venture capital firms, and public equity investors are investing heavily in AI platforms, chipmakers, and infrastructure. The surge in AI enthusiasm is driving elevated valuations for both tech sector equities and broader market indices, with the US at the center of it, much like the tech bubble at the turn of the Millennium. The question is what’s different this time?

Nevertheless, despite enthusiasm, conditions are not as manic as those of prior bubbles (e.g., the dot-com era in 1999 or the Financial Crisis in 2008), but the valuation context is unmistakable. The current era of high valuation post-Pandemic does not appear extreme relative to prior periods when evaluated by the Buffett Indicator, which measures equity wealth as a percentage of GDP (Exhibit 2). Yet, the indicator remains extraordinarily high by historical norms at nearly double what it was forty years ago. This valuation should trigger caution given its predictive record for long‑run returns. While the technology sector has unquestionably contributed to growth by accumulating monopolistic profits globally, the presence of another factor is also critical to its ascension.

Exhibit 2. Total Household Financial Wealth as a Percent of GDP

Source: Board of Governors of the Federal Reserve System, retrieved from FRED

Mounting Debt. As the barons of private equity’s leverage buy-out club know, financial leverage increases equity returns and imposes cost discipline on the sub-optimal companies they target. The same effect occurs with Federal government debt: the leverage augments growth (usually during a period of unexpected deficit) in the short term. Except for the wild years between 1981 and 1992, Federal debt relative to GDP increases have been the providence of a fiscal response to a financial crisis or pandemic (Exhibit 2). Yet, the driver is less critical than the current situation: Federal liabilities sit at 114% of GDP, a level not seen since the post-World War buildup.

This relative level has historically marked the end of the debt boom. Indeed, if not for the Pandemic and the fiscal and monetary stimulus it delivered, the debt buildup may have eased.  Instead, government borrowing ramped up to fight the ravaging effects of the Pandemic and postpone the credit comeuppance for another day. The impact of this increased debt may make the reckoning more difficult in the future as the government's capacity to borrow becomes more limited. Critically, if interest rate levels persist, there is no way to resolve the deficit other than through drastic cuts in spending or materially higher taxes, both of which are growth-depressing.

Exhibit 3. Total Federal Liabilities as a Percent of GDP

Source: Board of Governors of the Federal Reserve System, retrieved from FRED.

Untaxed. The two opposing forces of government’s role in society are those that support the Keynesian dictate of taxation for public goods (e.g., fire and police) and evening out inequities (e.g., public education), and the Friedman cult, who see no role for government (e.g., tax reduction) and capitalism as the answer. Yet, some goods are required (even demanded), and increasing taxes (in the US, at least) can be a ticket out of office. This situation can result in a perverse outcome of increasing expenditures without corresponding tax increases. The trouble arises in determining who receives tax cuts and who does not.

Tax revenues as a percent of GDP have varied between 15%-20% of GDP for over 75 years (Exhibit 4). This consistency in taxation, however, was not evenly shared. Corporate taxation as a percent of GDP fell from around 5% to under 1% in 2020. As the Federal government became more leveraged, corporations enjoyed a lessened tax burden. One does not need a storied business degree from Harvard in this environment to grow profits: the Federal government borrows to spend, increasing corporate revenues while taxing earnings at a lower rate. The corporate pie grows while keeping more of it.

Exhibit 4. Tax by Major Components as a Percent of GDP

Source: Board of Governors of the Federal Reserve System, retrieved from FRED.

Pure Profit. There are credible arguments that technology monopolies (e.g., Google and Meta) extract economic rents from a worldwide market that enable superior earnings. Yet, the scale of the growth in earnings is unprecedented. For fifty years, corporate profits were approximately 6% of GDP; however, since 2000, profits have averaged around 11% of GDP, nearly a doubling (Exhibit 5). Unquestionably, technology has enabled superior operational performance, yet a simple critique remains: why are these abnormal returns not competed away by the competitive market that Friedman espouses? Fortunately, the story is rather mundane: government policy.

As every attentive student of finance knows, the value of a stock is the present value of its future cash flows. Corporations are permitted to exercise the economic rents on their monopolies, thereby ensuring that they enjoy enlarged profits. Further, less taxation is asked of these same profits. Both actions conspire to deliver returns well above contemporaries in Europe and Asia, who must bear the burden of meeting their societal requirements. As the trustbusters knew at the beginning of the 20^th century, permitting the few to benefit at the cost of the many leads to social unrest. Cake anyone?

Exhibit 5. Corporate Profit as a Percent of GDP

Source: Board of Governors of the Federal Reserve System, retrieved from FRED.

Abnormal Value. Price is not a determining factor of investment outcomes: value holds that distinction because any price is valid should the prospects be high enough. Yet, this is where trouble arises for US equities: Shiller’s Cyclically Adjusted PE (CAPE) stands at a level only reached during the tech bubble of 2000 (Exhibit 6). While the possibility of further gains is possible, they require some degree of abnormal profit prospects merely to maintain the current level. Notwithstanding the potential of Artificial Intelligence to deliver productivity enhancements, there are structural headwinds for US equities and technology. Herein is where trouble arises.

Exhibit 6. Shiller’s Cyclically Adjusted Price-Earnings Ratio

Source: Robert Shiller, https://shillerdata.com/

The ability to further leverage the government balance sheet is limited, despite the policy intentions of the current US administration. This limits the choices of the Federal government: it must either cut spending or increase taxes. The latter was just shown to be operationally complex, which leaves the latter. Even an Ivy League-trained strategist can deduce the target for taxation of the reelection-seeking: the corporations that don’t cast a vote. As the animus in the US continues to grow and choices narrow, the prospects for change will emerge slowly, then suddenly. While the current administration is an unlikely catalyst, its demonstrated volatility suggests that change could arrive.

[1] TACO = Trump Always Chickens Out

This excerpt is the macro view from our GPS 25Q2. Read the complete report here.