GDP = C + I + G + (X – M).

The above equation provides one way to conceptualize economic activity for a country. It makes the relationship between Consumption (C), Investment (I), Government spending (G), and the difference between exports and imports (X-M). Simple in form. Impossibly complex in function.

For decades, the U.S. economy advanced on a set of shared assumptions: cheap goods from abroad, stable institutions at home, and a government that could run persistent deficits without anyone raising too many concerns. Then came the new administration — and with it, a growing sense that none of those assumptions are sustainable anymore.

And as we have experienced over the past three months, they’re not thinking surgically — they’re going straight for the shock paddles. Each part of the economic system is being jolted: not because it’s entirely failed, but because they fear that without intervention, it soon might. Secretary of the Treasury Bessent recently called this moment one of “strategic uncertainty” — a phrase that captures the strange tension of bold action under fragile confidence.

What’s striking isn’t just the presence of significant change — it’s the simultaneity of it. Each element of the GDP equation is being pulled into the reform agenda.

A quick aside. We will spare you all any political opinions we may have, as they are meaningless when it comes to investing. Instead, we want to discuss the various puzzle pieces that we see in our attempt to see the larger picture. We should note that this discussion will not result in a change to our investment directions. Our investment process continues to be built on time-tested empirical studies that measure investor behavior and risk tolerance within the global investment ecosystem. Attempting to develop an economic forecast when there is so much uncertainty is unproductive and, in this case, manic.

Upon the changing landscape, two questions come to mind: 1) Why the urgency around government spending, and 2) Why the need to forcefully restructure trade? It appears that those two questions are at the root of many of the policies being enacted.

The answers to those questions may substantiate the need for such drastic adjustments. The answer to the first question revolves around a material change in deficit spending over the past decade. As the Deutsche Bank chart below shows, the U.S. has been running an extremely large deficit, even as the economy continues to chug along at a steady pace. The possibility is that the country may enter a precarious situation, which has led other countries to experience economic shocks as they approach a debt-to-GDP ratio of 150%. Is the U.S. comparable to those other countries that hit that turbulence? No, but do we want to test it?

The answer to the second question appears to be the growing concern amongst both political parties that the U.S. needs to reduce its dependence on China. The new administration has added color to this discussion, believing that the era of the globe having a single global power is over, and we are back to a multipolar global environment. With the fall of the USSR, the world saw the U.S. fill the vacuum. Over the past two decades, China has grown to a size comparable to that of the U.S. in terms of economic strength and global reach. Right or wrong, the new administration sees a need to adjust decades-long policies to a new reality.

As stated earlier, the path being chosen touches and tests every component of the equation. Although the U.S. consumer is in strong shape, consumption is entering uncertain territory. For years, Americans have benefited from a global trade system that prioritized cost efficiency, even if it meant geopolitical dependency. It led to two decades of pricing disinflation. That changed somewhat under the prior administration as concerns about global warming led some to shift from the focus on faster, better, and cheaper to faster, better, cheaper, and less harmful. The new administration wants to refocus attention on faster, better, cheaper, and more strategic solutions. With the drive for new tariffs and supply chain reshuffling now on the table, it isn’t easy to imagine an environment where goods pricing does not need to adjust to a higher norm. That may serve strategic goals, but it also tests the limits of consumer tolerance in a system that has long relied on abundance at low cost.

Investment plans are also undergoing significant realignment. New policies and trade negotiations are driving new investments into the U.S. for sectors such as semiconductors, artificial intelligence infrastructure, and domestic energy production — areas viewed as essential not just for growth, but also for sovereignty. This is likely to have a positive impact, although there is uncertainty surrounding the timeframe. For example, we recently read “Apple in China” by Patrick McGee, which highlights the impact that corporate investment can have on a country. He highlights that Apple’s move to China for manufacturing at the turn of the century resulted in Apple training over 28 million Chinese in leading-edge manufacturing practices. Interestingly, he draws an analogy to the Marshall Plan following World War II, which helped rebuild Europe. Using that as a measuring stick, Apple’s investment in China was equivalent to the size of two Marshall Plans focused entirely on one country.

Government spending is undergoing philosophical triage. The deficit is growing, the national debt is flashing warning lights, and the last of the major credit agencies just downgraded U.S. sovereign debt from AAA. So, while the dollar remains dominant for now, there’s less breathing room than there used to be, especially if pundits are correct about the fear of China’s growing global footprint. Few will question the inefficiency in federal programs, but the current actions are likely to lead to the cutting of muscle, not just fat. With government spending accounting for around a third of the economy (larger for specific sectors), a significant adjustment in spending will likely have ripple effects for some time as public and private institutions adjust to a new environment.

And then there’s trade — the (X–M) term that used to live quietly at the end of the equation but is now center stage. Reshoring and “friend-shoring” have replaced globalization as policy priorities. The U.S.-China relationship has shifted from pragmatic interdependence to strategic decoupling. The “Red Curtain” that seems to be rising now is more complicated than the Iron Curtain ever was: it’s not just ideology, it’s supply chains, pricing power, capital flows, and trust.

As engineers, we understand that every equation comes with error bars for each component, which help to frame the potential variation in calculations. Those have grown over the year, suggesting that we are in a period of greater uncertainty. The economy isn’t falling apart, but it is being reassembled while it continues to operate. Markets, naturally, are struggling to translate intent into likely outcomes. Earnings forecasts for 2025 came down in the early part of the year but have remained surprisingly firm, high single digits for the S&P 500 — but there’s a growing sense that conviction in any direction could be dangerous. Forecasting in an environment where the inputs are still shifting is like trying to steer with a compass during a magnetic storm.

In moments like these, it’s easy to mistake uncertainty for collapse. But there’s another reading, too — one rooted in generational cycles. The Fourth Turning, by Strauss and Howe, describes a recurring pattern of societal reset, in which old institutions falter and new norms are forged under pressure. These periods are messy, but they are also necessary. Reform doesn’t happen in spring. It starts in winter, when the ground is frozen, and the future looks hard.

There’s no guarantee that the current policy direction will succeed. Still, the underlying goals — rebuilding institutional credibility, reshaping critical dependencies, and revitalizing productive capacity — respond to concerns that are broadly acknowledged, even if the strategies provoke debate. This isn’t about choosing optimism or pessimism. It’s about humility. About recognizing that we are mid-transition, and that clarity, like a harvest, doesn’t arrive the moment seeds are planted.

So we stay alert. Strategic uncertainty doesn’t call for bold predictions; it demands humility and vigilance. We ground our approach in signals that have proven their worth through past periods of economic and political unrest, resisting the urge to chase headlines or cling to tidy narratives. We remain skeptical of certainty, and cautious of promises—whether they suggest smooth sailing or inevitable collapse. Because in times like these, it’s not the volatility that breaks portfolios. It’s overconfidence in a single path forward.

We want to focus on two economists with different ideas, Thomas Malthus and Joseph Schumpeter—different in areas of focus and outlook. We start with the downer, the quintessential pessimist, Malthus.

Malthus proposed a theory in the late 18^th century that population growth was exponential while food production was linear, leaving no option to avoid catastrophe other than population control. No one can state it as eloquently and depressingly as Malthus, “The power of population is so superior to the power of the earth to produce subsistence for man, that premature death must in some shape or other visit the human race.” Suffice it to say; he wasn’t invited to that many bashes (author speculation, unconfirmed). However, it would have been fun at a party, if he did attend, to holler whenever he sampled the hors d’oeuvres, “Hey Tom, how many peasants do we need to kill for you to have that one?”

Though his theory was specific to population growth and food production, we see it aligned with the “zero-sum” line of thinking. Zero-sum is a term from game theory, and it assumes that in a game played between two participants, if one wins, the other party loses, with no change in the total sum of wealth. In other words, it relies on the belief that the total wealth at play is static, or—and we’re stretching here—in the case of Malthus, the idea that some items are limited and near fixed. We are taking some liberties with this line of thinking by attempting to highlight that what zero-sum thinking and Malthus’s views have in common is the omission in their theories that factors outside their purview may lead to a dramatically different outcome from that presented by their theory. Malthus did not include in his thoughts an adequate view surrounding farming productivity and yield enhancement. Because of that, his theory has been wrong since proposed. Since introducing his theory, the global population has increased tenfold, and current food production is 20% above the need. Malthus and those promoting zero-sum ideas limit their arguments to an incorrect and static view of the variables within the equation, leaving us with only unpleasant options surrounding restriction and sacrifice when human ingenuity has produced better outcomes for an ever-growing world population.

And this is where we turn to the other economist, Joseph Schumpeter. Coming on the scene about a century after Malthus, Schumpeter came to be known for his appreciation of entrepreneurship and innovation and their positive effects on the economy. He criticized the Malthusian ideal—arguing against economic models that froze all but a few of the variables. He reasoned that the arbitrary reduction of economic complexity to a monotonic view of inputs (i.e., if this, then that) would lead to false confidence in a policy decision that was likely to be wrong.

Schumpeter was an optimist (concerning economic growth) and promoted the belief that human ingenuity was the primary driver of economic prosperity. His work attempted to show that waves of innovation spurred economic growth. Innovation was brought on by individuals acting as entrepreneurs, aiming to offer new products or services to fill a need or reduce some economic inefficiency. He promoted the idea of creative destruction whereby new products would displace lesser products and bring about new opportunities and new, more stable economic outcomes.

Why do we bring these two up?

A Malthusian perspective focuses on the eventual—if the population grows exponentially, the world will eventually run out of food. A Schumpeterian view aims to address near-term opportunities—if the soil is enhanced with fertilizer, crop yields will increase this year. Malthus sees resources being depleted eventually with no expectation of adaptation or modification, with the only option for a healthy society being the restriction of consumption. Schumpeter considers the intermediate-term benefits driven by innovation and the increased efficiency that comes from it as a likely means to meet the needs of expanding populations.

Today, we see both theories permeating our lives, with Europe an excellent case study.

The EU energy crisis offers an example of the two theories in action. European governments have been the most active in converting to renewable energy sources. They have taken a Malthusian approach to conventional sources by instituting barriers to fossil fuels to address fears of rising global temperatures. At the same time, enormous efforts have been made by the private sector to explore innovative solutions to produce cleaner energy sources. The situation in Europe highlights the ramifications when those two theories are enacted yet not managed to perfection.

For a decade, countries within the EU have been shutting down energy sources that generate CO2 and nuclear. France and Germany have been leading the transition by outlawing oil fracking and extraction with the hopes that Russian natural gas would act as a bridge to enacting their renewable energy plan. Unfortunately, that plan failed. With the Russian/Ukraine war cutting off a material amount of their energy, they are faced with no easy answers to their winter energy needs. This mismatch in timeframes where the long-term desire to move off fossil fuels has not been matched with innovative solutions ready for large-scale use has seen German energy costs increase tenfold in the last year. Energy price inflation is bleeding into almost all other goods and services as the EU industrial complexes are forced to shut down production. With no quick relief in sight and higher energy prices rippling through the economy, the result appears to be higher-for-longer inflation.

This inflation is from man-made scarcity. And it appears there are only two paths to take: reduce the scarcity by re-opening conventional energy supplies or cut demand to the point of equilibrium. The former is politically unattractive and the latter results in a deep European recession. With the European Central Bank raising rates as an attempt to thwart inflation, it appears they have chosen the second path.

Hangover

What follows is not a segue from the prior conversation but a separate reflection on liquidity. We frequently discuss liquidity within the investment market. Liquidity is the amount of money that flows within the system. Think of it as the oil in the engine—it lubricates the moving parts, allowing them to move with less friction and wear. Our models revolve around identifying market liquidity changes, watching for when it becomes scarce, and risks disrupting the economy. We have been highlighting liquidity issues starting in late 2019. The monetary and fiscal stimuli in response to the pandemic offered some reprieve, but those acts have driven higher inflation and masked underlying weaknesses. With a concerted effort by central banks to contain inflation, this tightening liquidity phase will likely last a bit longer and result in a bit higher than expected interest rates.

If we are entering a period of lower liquidity, it may not be just the investment market negatively impacted. It is hard to assess excess liquidity’s indirect benefit on the economy accurately. Real estate transactions might take longer to complete; credit card limits might be reduced; zero-interest installment payment plans might end; start-up funding might become smaller and harder to obtain. The time to go from idea to production to self-sustaining sales will likely stretch. Companies will likely need more investments at a time when investments become harder to find.

We have not seen a sustained decline in money within the system for more than 40 years. Determining what its impact will be is tough. Very tough.

These concerns inform our current defensive positioning. With pundits arguing the extremes, peddling an all-or-nothing solution to investing, we sit in-between. From our perspective, being entirely out of the market is a very rare situation involving a banking crisis. We are not there, but we are hunkered down for a challenging period during an anticipated global economic reset. We sit with 35%+ cash for our equity-only strategies, and our balanced strategies have less than half the equity of their respective benchmarks. Over our time writing this newsletter, we have described market tops and bottoms as processes, not points in time. We wish we could pinpoint market inflection points but can’t, like all others. The most we can say is that we are in a market-bottoming process now. We know that these are the times that opportunities present themselves and need to be balanced in our views in order to act on them.

In our May 2021 newsletter, Breaking Windows, we discussed inflation and its impact on the investment markets. We said the primary drivers of inflation were the large stimuli injected unevenly into the global economic system through governments and central banks. That newsletter focused on one side of the equation—demand—and in it we noted: “There is an argument to be made that persistent inflation is unlikely without a scarcity of core, non-discretionary inputs. (Think back to oil in the 1970’s).”

In May, we hoped inflation in the U.S. would be transitory as the world reopened with pent up demand. However, what we fear now is that pockets of scarce supply will continue to put upward pressure on prices because ongoing pandemic-induced precautions and changing priorities by governments around the globe appear to be entrenched.

Over the previous four decades, the world’s population has experienced a fantastic non-inflationary, consistently expansionary (NICE) economic landscape. The term NICE was coined (pun intended) by the former head of the Bank of England, Mervyn King, who said, in 2008, that the U.K. was likely exiting this golden period. He was speaking only of the U.K., but he could have applied his assertion to most developed countries. Up until the Global Financial Crisis, the U.K. and the world at large had been experiencing moderate global inflation and relatively smooth economic expansion. Since his comments, and until the present moment, inflation has continued to be moderate, but economic growth has become more volatile as economies increasingly depended on easy monetary policies and financial leverage. Today, with inflation perking up and unstable economic growth, Mr. King’s end-of-NICE concerns might finally be coming to fruition.

The global NICE period started in the mid to late 1970s as the U.S. started a wave of privatization, deregulation, and the breakup of government-enforced monopolies (e.g., Ma Bell), all of which reduced barriers to entry, expanded the competitive landscape, and drove a multi-decade investment cycle focused on creating better, cheaper, and faster solutions.^[1] It was not only the U.S. that saw this low inflation period of growth. We saw it, too, with the fall of the Berlin Wall, and with the integration of the Iron Curtain countries into the Western European economy as both end markets and centers of manufacturing. The period got new momentum as communist China opened a bit, offering a large untapped labor force and, over more recent decades, a prosperous consumer hungry for Western goods.

Once static industries were able to opportunistically adopt technological innovations and cross borders to source optimal labor and service new end markets, economies of scale brought more value to an expanding addressable market. Over the course of three decades, the world witnessed a dramatic decrease in extreme poverty. More than a billion people moved up the wealth curve, producing new consumers along the way. The immense new resources allowed for a non-inflationary environment to flourish even as economies across the globe grew rapidly.

Today, we might be in a different situation. The political big bang of expanding individual freedom and freer trade has stopped, and the data indicates individual rights and the freedom to transact seem to be contracting. The Institute of Democracy and Electoral Assistance (IDEA) recently released a report showing that the number of democratic governments in the world has declined, and a growing number of those still democratic are under threat. The most obvious examples are Russia and China, who are restricting economic freedoms to further their political agendas, constraining economic energy and diverting it to less productive areas. As one example, China has stopped importing coal from Australia, forcing power outages across the country, because the Australian government promoted an international investigation of China’s handling of Covid-19.

The IDEA report also highlights that the pandemic has led to a surge in authoritarian behavior by even the most democratic governments, as many around the globe experience mandatory lockdowns and travel restrictions. Pandemic-induced scarcity through restricted movement has caught many’s attention, but other factors not necessarily related to Covid have led to a material change in the availability to economic inputs.

Let’s use three examples—the global energy sector, U.S. supply chains, and the global labor market—to explore this cause and effect.

Regarding energy costs, governments around the world have been pushing for greater reliance on renewable energy. Developed market countries have quickened the prioritization of renewable energy as they feared the impact of their use on the environment. The U.K. moved aggressively into wind power, simultaneously reducing their investments in fossil fuel facilities, which resulted in energy shortages recently when the wind wasn’t blowing. Europe has been aggressive in moving away from traditional energy sources, as well. France—which has the second largest reserve of shale gas in Europe—banned fracking in 2011, and in 2017, it banned all new oil development, setting the stage to cease all production by 2040. Germany enacted legislation in 2011 to move away from nuclear energy, causing a heavier intermediate-term reliance on fossil fuels at the same time the government was also restricting investments in that space.

Restricting production does not correspondingly change demand, however, which has continued to grow in these countries. As a result, France and Germany have become increasingly dependent on Russian natural gas at a time when Russia is flexing its muscles politically and economically in direct opposition to European democratic ideals.

Our second example is the U.S. supply chain.

Monetary and fiscal stimuli allowed for greater consumer demand during the pandemic than expected, forcing companies to play catchup after depleting inventories at the start of the pandemic. Many firms are also changing their supply strategies from a pre-pandemic, just-in-time approach to a post-pandemic, just-in-case one. Even so, misjudging demand does not explain why port congestion— understood to be a major contributing factor to the U.S. supply chain problem—is worse on the West Coast than the East Coast. The East Coast (representing about 19% of U.S. import capacity) is not experiencing the same level of congestion as ports in California (that represent about 28% of import capacity). If we look under the hood, the problem may exacerbate the downstream effects of California’s regulation of ride-sharing companies.

The American Trucking Association estimates that the U.S. is short about 80,000 truck drivers. Yet, reports estimate that more than 460,000 commercially licensed truck drivers resided in California in 2019 and only half of them are operating right now. The shortage might be due to many California truck drivers—especially those that worked as independent contractors at the ports—having either left the state or taken other jobs because of a 2020 state law requiring companies to classify independent contractors as employees, increasing the cost burden on an already stressed system. The law had ridesharing apps in its sights, but truckers were in the line of fire also, leaving many to move on to less restricted job opportunities. Because California is the entry point to well over a quarter of the U.S.’s imported goods, it’s regulations can have a ripple effect throughout the U.S. economy.

Government laws are also impacting the more general labor force. The near-term consequences of virus-based restrictions are, for better or for worse, producing labor scarcity. With each new variant, the threat to labor is renewed.

This challenge is not unique to the U.S. The Philippines have instituted a “no work, no pay” rule for their unvaccinated population. Canadian employers are responding to an expected government mandate by firing or putting on leave unvaccinated employees, even as they experience a tightening labor market. The U.S. has set a January 4 deadline for large employers to have their employees either fully vaccinated or tested on a weekly basis. In other words, the global labor shortage, amplified by mandates, is becoming an ongoing issue.

A very rough estimate is that unvaccinated adults make up about 20% of the U.S. labor force. A little over a third of the unvaccinated have responded to polls saying they will leave their jobs if their employer mandates a vaccine or weekly testing. We are not sure how this will end, but we can see the likely initial result is more scarcity in labor.

The shift to a more regulated environment reminds us of the philosopher Zeno’s dichotomy paradox, which argues that a person walking between two points must first walk halfway. And before they can walk halfway, they must first walk a quarter, and then an eighth, and then a sixteenth. Zeno extrapolates this to the point where a person must walk an infinite number of infinitesimal distances to get to the destination. And the one thing we know about infinity, it’s a long way away.

We bring this up not because the distance is impossible to complete, but because the rules put onto the mission, and the myopic perspective they encourage, produce what seems to be an impossible objective. We see something similar in our world today, with blunt laws, rules, and attitudes combining to artificially and illogically increase the distance to our objective, which in this case is reducing scarcity.

The likelihood that scarcity will continue, and inflation will remain higher for longer is becoming embedded into the fixed income markets. We mentioned in late summer the degradation we saw in the credit markets as Chinese property developers were experiencing rising rates of default. Credit markets have continued to deteriorate, overcoming the positive momentum in world equity markets. We have long highlighted investment markets lacking fundamental valuation support and, currently, we are adding the observation that credit markets are showing fatigue. We see it as a time to increase our level of conservativism. We have recently moved the portfolios to be a bit more cautious, raising cash levels to 20% across all strategies.

1. We are firm believers that evolution towards better outcomes is a never-ending process yet over modern times, we have experienced innovation cycles where the advancement in cheaper, better, faster accelerates and decelerates. We think this graphic does a better job than we could at depicting the recent cycles in technological advancement. ↑