Beware Vigilantes

I’ve been asked a lot for thoughts about the new “Department of Government Efficiency,” and specifically what it might mean for defense and government IT stocks. The real answer is: “I don’t know.” There isn’t a lot to go on right now, other than one-liner promises and tweets. It’s hard to analyze something that doesn’t yet exist in a concrete real form.

But that’s not to say it should be ignored. As Howard Marks notes above, although it is stupid to try to predict the future it is even more stupid to not take stock of the present.

Quick disclaimer: It is hard to go here without getting a little political. I’m going to do my best to avoid it but almost certainly I will say something here that offends someone’s political sensibilities. Perhaps everyone’s. That’s not my intention. I don’t care who you voted for, and you shouldn’t care who I voted for. Good/bad/whatever the best we can do is assess the realities of the moment.

Back in the 1980s, a time so long ago I had hair, economist Ed Yardeni coined the term “bond vigilantes” to describe the bond market’s oversized impact on keeping federal spending (at least a bit) in check. To (greatly) oversimplify, the government is constantly rolling over its debt and so constantly needs the market to be receptive to new issuances. When the market dries up, or becomes prohibitively expensive, bad things quickly happen to the economy.

Bad things also happen to those in charge of those economies. George H.W. Bush famously said “read my lips: no new taxes” at the 1988 convention on his way to becoming president. He lost his bid for reelection four years later in no small part because, despite what his lips said, he raised taxes once in office. He wasn’t intentionally being dishonest. He wasn’t tricked by those sneaky Democrats. Rather, (again oversimplifying) the bond markets made him do it. And he paid the price.

More recently, Liz Truss is now a footnote in history and the target of a lot of jokes thanks to her 44-day term as Prime Minister of the United Kingdom back in 2022. Many words have been written on the reasons for her short tenure. But for our purposes, and again admittedly oversimplified, Truss’ plan to cut U.K. taxes sparked a revolt in the bond markets, leading to a revolt against her.

Fast forward to today. The incoming administration, like all incoming administrations, has big plans. They want to extend the original Trump tax cuts but also spend billions on new initiatives like AI and missile defense. Both tax cuts and spending, by themselves, lead to higher deficits.

To be clear, there is nothing (really) stopping the White House from adding new debt. Sure, there are checks and balances and debt ceilings and all of that theater, but those things tend to get worked out eventually. And they should be pretty straightforward right now with the same party in control of both the White House and Congress. If so, the only thing really standing in the way is those dreaded bond vigilantes.

Since the end of the first Trump term, U.S. government interest payments have surged from less than 2.5% of total GDP to nearly 4%. That’s a combination of increased debt and higher rates, of course, but whatever the reason the net impact is the same. For reference, that is still far below the nearly 5% of GDP range of the first Bush term. So, we are not in the danger zone yet. But it is trending in the wrong direction.

With all this mind, keeping the bond markets calm should be one of the top priorities of the Trump Administration. Again, there are no (insurmountable) political limits to the amount of debt the nation can take on. Debt can continue to soar higher with very little (near-term) consequence, as long as the bond markets don’t revolt.

Which brings us back to DOGE. If I was an adviser to the new Administration (disclosure: I am not) my number one priority would be to communicate discipline to the bond markets. To show them government efficiency is a priority. To perhaps even make grandiose gestures like offering (vague) buyouts to government employees. And to make war with government contractors.

The important thing to remember here is that, in many scenarios, this will end up being more bark than bite. Again, it doesn’t really matter how much you cut as long as bond investors believe you are aware of the risk and cutting is a priority. You are buying yourself time or kicking the can down the road (depending on your political point of view).

This is all just a fancy way of saying that I expect a lot more rhetoric than action, and I expect things to calm down and get into a flow sooner rather than later. And assuming bond markets cooperate. This is not an administration that looks likely to risk looking weak on defense, and government IT firms could actually end up beneficiaries if work is outsourced.

Defense investors should be aware of some smaller risks. For example, it is possible the administration follows through on its talk of shifting more work to fixed payment (you get what you agreed to, regardless of what your costs are) instead of cost-plus (the government agrees to cover your expenses plus provide a small margin). That adds more uncertainty for the contractors, but for well-run companies operating in areas they know well and who have the ability to control costs it also creates opportunities for margin expansion.

Back to the broader point, the biggest uncertainty surrounds questions about whether the rhetoric will work. One could argue trading $100 billion worth of tax cuts (definitely happening) for $100 billion worth of potential government efficiency savings (uncertain) is not a great trade. If bond markets do not cooperate, tough choices will have to be made about whether to pursue tax cuts or spending priorities or to cut back in both areas. The most important thing to watch, therefore, is the temperament of the bond markets. Until I see panic there, I don’t expect panic elsewhere.

My best guess is that defense IT will do fine in the long run, though near-term volatility is almost certain. And bond investors interested in intermediate lengths are likely going to look back fondly on this moment.

But who knows. As Howard notes we have no idea what the future will bring, or how quickly it will arrive. The best we can do is try to figure out what is going on in the present.

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