Fiscal Fortitude: Why U.S. Equities Thrive Amid Deficit Debates

The U.S. fiscal landscape has reached a pivotal moment. On May 16, 2025, Moody's downgraded U.S. sovereign debt to Aa1, citing unsustainable deficits driven by rising federal spending and tax cuts. Concurrently, the One Big Beautiful Bill (OBBB), a sprawling legislative package, seeks to reshape fiscal priorities through SNAP reforms, agricultural subsidies, and tariff adjustments. This article argues that historical precedents—from the 1937-38 recession to Japan's 1997 fiscal tightening—warn of the dangers of abrupt deficit reduction. In contrast, prolonged fiscal support is critical to sustaining growth, making equities an attractive bet despite bond market skepticism.

Historical Lessons: When Fiscal Austerity Backfired

In 1937, the U.S. economy was recovering from the Great Depression when President Roosevelt and Congress slashed spending and raised taxes to reduce deficits. The result? A sharp contraction—the 1937-38 recession—erasing half of the previous gains. Similarly, Japan's 1997 consumption tax hike, aimed at curbing debt, plunged its economy into a decade-long slump. Both episodes reveal a clear pattern: abrupt fiscal tightening risks derailing recoveries.

Today, the U.S. faces a similar crossroads. The OBBB, while expanding farm subsidies and rural investments, also imposes strict SNAP eligibility rules and shifts costs to states. Yet, unlike 1937 or 1997, the current fiscal stance prioritizes growth over austerity. The bill's $4 trillion in projected deficit expansion—via extended tax cuts and spending—mirrors the post-2008 stimulus playbook, which many credit with preventing a deeper slump. This differentiation is key: current deficits are investment-driven, funding infrastructure and defense, whereas past cuts targeted safety nets.

Current Risks: Tariffs, Inflation, and Fed Dilemmas

The OBBB's tariff provisions complicate the picture. By raising import taxes on Chinese goods and extending Section 232 tariffs on steel and aluminum, the bill aims to protect domestic industries. However, CBO analysis reveals a stark distributional impact: the bottom 10% of households face a 6.5% income reduction due to higher prices on essentials, while the top 10% gain 1.5%. This inequality could dampen consumer spending, a linchpin of U.S. growth.

Meanwhile, Federal Reserve officials like Atlanta Fed President Raphael Bostic warn that tariffs risk prolonged inflation. Unlike transitory price spikes, structural tariff costs could force the Fed to delay rate cuts, raising borrowing costs for businesses and households. Yet, equities have shrugged off these headwinds: the S&P 500 has risen 15% year-to-date despite the Moody's downgrade and bond markets pricing in higher yields.

Why Equities Remain Resilient

1. Fiscal Multipliers in Action: The OBBB's agricultural subsidies, rural investments, and defense funding ($60M for 1890 Institution scholarships) directly boost corporate earnings. Companies like Deere (DE) and Tyson Foods (TSN) benefit from farm support, while defense contractors (e.g., Raytheon Technologies RTX) gain from missile and munitions spending. Even amid tariffs, the bill's $2.4 trillion in tariff revenue—though contentious—provides a fiscal cushion.

2. Equity Valuations vs. Bond Market Pessimism: The bond market's reaction to Moody's downgrade—10-year yields spiking to 5.2%—reflects structural concerns. However, equities have decoupled because earnings growth remains robust. S&P 500 earnings per share (EPS) are on track for a 7% rise in 2025, buoyed by fiscal stimulus and cost-cutting. Contrast this with the bond market's focus on debt-to-GDP ratios: equities price in future growth, not just present liabilities.

3. Global Context: Unlike Japan in 1997, the U.S. retains global economic hegemony. The dollar's reserve status, coupled with the Fed's flexibility, gives policymakers room to maneuver. Even with a Moody's downgrade, U.S. debt remains a “least bad” option for global investors fleeing European and emerging market instability.

Investment Strategy: Overweight Equities, Mind the Sectors

• Agricultural & Infrastructure Plays: Overweight companies benefiting from OBBB's farm subsidies and rural development funds. Examples: Deere (DE), Archer-Daniels-Midland (ADM), and Caterpillar (CAT) for construction.
• Defensive Sectors: Utilities (e.g., NextEra Energy, NEE) and healthcare (e.g., UnitedHealth, UNH) offer stability amid inflation uncertainty.
• Avoid Tariff-Exposed Sectors: Consumer discretionary stocks (e.g., Walmart, WMT) face margin pressure from higher input costs. Rotate into sectors with pricing power, like software (e.g., Microsoft, MSFT).

Conclusion: Fiscal Support Is the Anchor

History shows that abrupt fiscal contraction risks collapse. The OBBB's flaws—notably its regressive income impacts—are real, but its growth-oriented deficits align with the lessons of 1937 and 1997. Equities, by focusing on earnings resilience rather than headline debt figures, remain the better bet. While bond markets grapple with Moody's downgrade, stocks will capitalize on the fiscal tailwinds. Investors should lean into equities, particularly those sectors directly benefiting from government spending, while hedging with inflation-linked bonds for volatility.

In short, fiscal fortitude—not austerity—is the path to prosperity. Equities are the vehicle to ride it.