Adrenaline markets: Fiscal expansion, tech, and tail risks

Equity valuations are elevated. The S&P 500 Index and the Nasdaq Composite have continued to reach new highs. We even debated the “B” word (bubble) at a recent Asset Allocation Committee meeting.

To be clear, no one on the committee is calling an imminent “pop.” The S&P 500’s high price-to-earnings ratio is, in part, justified by its composition. Highly profitable tech companies account for a historically large proportion of total market capitalization.

Besides, valuation isn’t the only factor that matters. Bullish macroeconomic signals abound. For example:

1. The “One Big Beautiful Bill” should be stimulative.¹ “The U.S. government is monetizing its structural advantages through debt. This will inflate asset prices,” said a committee member.
2. Artificial intelligence (AI) spending is accelerating, and company fundamentals behind this theme are strong. I’ve heard these same exact words about AI countless times from analysts and portfolio managers across our platform:
   “It’s real.”
3. Growth forecasts appear to have overreacted to the April tariff announcements and could normalize upward. June retail sales came in above expectations. Betting probabilities for a 2025 recession have dropped from 65% to 20%.²

So, why not overweight stocks given these favorable dynamics? Well, in addition to high valuations, several other risks to equities remain in play, including:

• inflation (still relatively low but ticking higher);
• long-end rates (we have a short duration stance in bonds); and
• policy, broadly defined as uncertainty around tariffs and geopolitics.

In that context, we believe a near neutral position on stocks versus bonds is the best way to manage both upside and downside tail risks.

A shot of adrenaline

From yield curve inversions to the Sahm rule recession trigger, the U.S. economy has shrugged off a host of classic recession indicators in recent years.

Once again, the U.S. economy looks to be holding its own in the face of headline risks. AI and fiscal spending are administering shots of adrenaline.

Financial conditions, already loose by historical standards, have been loosening further.³ Business incentives in the tax bill, such as permanent full expensing for capital investments and Research & Development, add further support to the U.S. growth outlook. And despite tariffs and geopolitical uncertainty, most investors still believe that Federal Reserve (Fed) rate cuts are a matter of when not if.⁴

Of course, markets outside the U.S. are also benefiting from a constructive macro backdrop. Central banks overseas have more latitude to cut rates, and many are already in easing mode, aided by relatively stable oil prices. Plus, fiscal expansion has helped to underpin growth in Europe and China.

These factors, combined with attractive relative valuations, continue to support our tactical investment thesis for market broadening over a 6- to 18-month horizon, led by international value and international small-caps.

To be clear, we’re not bearish on U.S. technology stocks and AI as a long-term theme. From a member of our Asset Allocation Committee:

“Look, as a committee, we focus on relative valuation opportunities. But at the same time, growth stocks’ fundamentals are excellent, better than value stocks’. If you account for earnings growth and free cash flows, the valuations of many growth stocks are reasonable. Let’s not worry so much about timing since these stocks are the long-term winners.”

To which he added: “AI? It’s real.”

A caveat on fiscal spending

I expect fiscal spending to be stimulative, but we can’t run the engine too hot. U.S. government borrowing isn’t slowing down (Figure 1).

U.S. government debt expected to remain high

(Fig. 1) General government debt as a percentage of GDP

As of April 23, 2025.
1 GFC = the global financial crisis.
2 ARP/PRAC is the American Rescue Plan/Pandemic Response Accountability Committee, IIJA is the Infrastructure Investment and Jobs Act, IRA is the Inflation Reduction Act, CHIPS is Creating Helpful Incentives to Produce Semiconductors Act.
For illustrative purposes only.
Source: U.S. Office of Management and budget (OMB)/Haver Analytics. T. Rowe Price analysis.

Treasury yields have managed to stay rangebound over the past few months. But any sign of bond investors getting nervous with debt levels or inflation could quickly push yields higher and curves steeper—threatening the “Goldilocks” conditions we find ourselves in.

Takeaways

Markets are reacting to more than just tariffs and Fed talk. There’s no sign of budget austerity. Inflation readings, despite a recent uptick, have been soft. Corporate earnings remain strong. Add it all up, and investors are realizing the world might not be falling apart after all.

The bigger issue is how all these forces interact—economic data, fiscal spending, inflation, and interest rates. That’s where our strategy focuses. We are neutral on risk, long diversification, and positioned for upside inflation surprises.