Range of possible policy and market outcomes has widened
In the 1990s, policy analyst Joseph Overton proposed a theory that policy proposals were only viable if they were deemed acceptable by the mainstream of the population. Proposals that fell outside this range were deemed to be unlikely to succeed, and sit outside what was subsequently renamed the “Overton Window”. Political scientists and economists have since recognized that the Overton window can be moved, or expanded. Through repetition, proposals that might previously have seemed extreme, can gain the imprimatur of acceptability. The US is certainly experiencing an expansion of the Overton window for public policy. The old order, in both domestic and foreign affairs, appears to be on its way out.

In introductory probability theory, students are taught to work with bell-curve shaped distributions, where observations cluster around a median, mean or prior readings. Abrupt changes are rare, and trends generally shift gradually. Outcomes that are very extreme are called “tail events”, they exist out at either “tail” end of a bell curve. Probability theorists will discuss extreme events, or tail events, or refer to distributions that have more outliers as having “fat tails”.
We believe the range of possible or even likely political and economic outcomes in the medium term has widened to include more extreme events. The Overton window for political events has moved internationally as veiled and not so veiled threats are made to trading partners. It has moved internally, as masked, armed agents of the state disappear people from the streets. This administration seems to relish confrontations and in human history such confrontations generally lead to a response from countervailing forces, followed by a stronger state response, in an escalating cycle of brinkmanship. The likelihood of tail events in markets have increased as businesses and market participants orient themselves for unexpected outcomes, most of which appear to be negative.
Though we are loath to give him further attention, Elon Musk has recently exited the administration and proposed creating a new political party. His critics have countered that he should focus on his business and ignore politics. We are not admirers of Mr. Musk in his business practices or politics, but we do believe his critics are misunderstanding something. All great fortunes, such as Mr. Musk’s, and even small fortunes are dependent on the law, which in the end is dependent on politics.
The political environment in the US has shifted abruptly over the past few months. Trade is now viewed negatively and the executive branch has accused several of our trading partners of taking advantage of the US by running trade surpluses. We agree that tariffs and industrial policy are valid policy tools, however, spurring domestic growth in industries requires assuring investors that relevant policies will be stable over the course of their investment. What we have seen over the past few months from the administration is constant zig-zagging, which makes longer term investment or capital allocation difficult or impossible. At some point, as enough business managers adopt a “wait and see” attitude, a slowdown materializes. A countervailing force here is business investment in the technology sector and adjacent industries around Artificial Intelligence. The potential rewards for early movers are believed to be so large that investment has continued unabated.
Yet here too, there are significant policy risks. The US is largely a service economy, which means most of what we produce, and the value of our economy is embedded in human capital– the accumulated knowledge and capabilities of its people–rather than assets in the ground or hard goods. This certainly applies to the technology industry, including AI related enterprises.
Large swathes of the knowledge economy view their livelihoods and even their entire fields of work to be at risk under this administration. This includes researchers at universities, millions of immigrants and federal workers in specialized fields from Air Traffic Control to the National Weather Service. We have seen anecdotal reports of teams and researchers receiving offers of employment from foreign universities and enterprises as word of this administration’s hostility towards academia spreads. Relocating factories overseas atrophied domestic production lines, which will now require years or decades to rebuild. The departure or mothballing of critical talent in the US will have a long-lasting impact as well.
Our major trading and political partners have surely begun to reassess the US, and it is unlikely that many will conclude the US is a bastion of stability. In international affairs, as this administration’s actions towards Ukraine and various Middle-Eastern countries demonstrate, we are playing a destabilizing role. Even staunch allies such as Japan are therefore reconsidering where their long term interests lie. We can see this reflected in global surveys, where the US’s favorability has fallen in almost all major countries (Financial Times, July 8, 2025: Trump’s assault on American greatness)
Amongst all this uncertainty, the US consumer has continued to spend. This resilience is partly due to equity markets themselves. The US has very high levels of income and wealth inequality compared to other developed economies. Almost half of all consumer spending is driven by the top 10% of US households. These households are wealthier and tend to have larger investment portfolios. That means they are more susceptible to the “wealth effect” which postulates households spend less when they feel less wealthy (for example if their investment portfolio value falls). Conversely, their spending remains unaffected if equity markets remain high as they have this year, despite the tariff-related selloff in Q1.
The US lost its AAA rating from Moody’s this quarter. Moody’s was the final holdout, the other major rating agencies had downgraded the US years earlier. This news came on the eve of Congress passing a budget that starkly erodes public finances. The CBO estimates the budget will add $2.7 Trillion to the US deficit over the next 10 years. The credit-worthiness of any borrower, even one as large as the US Treasury, rests on two factors: the ability to pay back its debts and its willingness to do so. This budget further erodes the US’s ability to repay its debt, but that is not all. Individuals close to the current administration have suggested it could unilaterally force foreign bondholders to swap their holdings for cheaper bonds, a prospect that creditors would view as a selective default (Financial Times, May 2, 2025: How China is quietly diversifying from US Treasuries). We can envision a day where we hear senior administration officials argue that a selective default targeting NATO members is one way to get allies to share the cost of past spending for armed forces. The administration has also broadly and repeatedly undermined the Federal Reserve (Financial Times, June 29, 2025: Donald Trump’s fiscal policy and Fed attacks imperil US haven status, say economists). Taken together, most sober analysts will conclude that the US has eroded both its ability and willingness to repay its debts.
That said, some of these events could surely blow over, and all administrations float ideas to gauge public sentiment, before backing off unpopular ones. While it remains to be seen how this all plays out in the coming months/years, we will be watching these developments closely.
We are occasionally asked what we see other investors as doing, and particularly those investors we consider to be the “smart money”. We will interpret the views of three investment firms we consider worth paying attention to in matters or asset allocation or risk analysis.
1. Berkshire Hathaway is a large conglomerate which has been led by legendary investor Warren Buffet for many decades. Since the beginning of 2024, Berkshire Hathaway has more than doubled its holdings in cash, from $167 billion to over $350 billion. The explanation from its management team is that there is a paucity of profitable investment opportunities. That is another way of saying Berkshire’s leadership believes equity prices are too high.
2. GMO is a Boston-based asset manager. Unusually for large institutional asset managers, GMO actively allocates within different asset classes and is a proxy for what the smart money on the “buy side” is thinking. GMO estimates the annualized 7 year, fair value return for Large Cap US equities to be -4.9% as of May 31, 2025. GMO does believe international stocks and certain “deep value” stocks in the US offer positive return outlooks for a seven year horizon, but growth stocks which make up the largest portion of major US equity indexes appear very much overvalued in their opinion.
3. Goldman Sachs, the global investment bank, has for the past several decades carved out a niche as one of the better connected and astute sell side firms on Wall Street. No major investment bank will publicly espouse a bearish position. We can, however, see what Goldman is doing with its own book. The Fed recently completed its annual stress test for systemically important institutions, which includes Goldman Sachs. Notably, Goldman’s portfolio suffered very small losses in the scenario outlined by the Fed which includes a 40% drop in US equity prices. (Financial Times, July 2, 2025: How Goldman Sachs won big in the Fed’s annual stress test). Many observers have suggested this indicates some foreknowledge at Goldman of the test’s contours. The simpler and more direct interpretation is that the leadership at Goldman has decided to hedge much of its tradable securities portfolio because it does not like the risk-reward profile.
In Q2, equity markets rebounded from the tariff-driven selloff in March/April to set new all time highs. Some of this rally can be attributed to institutional equity managers who became overly defensive during the selloff and either went entirely to cash or shorted equities to hedge their portfolios. They are now playing catchup and have been deploying cash back into the market now that the rally has shown legs. While equities may continue to push higher from here, the circumstances that precipitated the sell-off – the Trump administration’s unpredictability around policy, their aggressive tariff stance and signs of weaker economic data– remain largely unchanged. As a result of this recent rally, equities are once again trading near all-time multiple valuations, which in the past has been a red flag signalling an eventual correction.
Because of these factors we continue to recommend a defensive, balanced allocation for most investors, in keeping with their long term goals.
Regards,
Louis Berger
Subir Grewal, CFA