Deficits contribute to rising U.S. debt levels, yet they also drive up corporate earnings and stock prices; therefore, analysts caution that cutting deficits might spark a financial crisis.

How Soaring U.S. Deficits Are Fueling Corporate Profits and Stock Prices

America’s national debt has surged beyond $38 trillion, driven by persistent and substantial budget deficits. According to Research Affiliates, these deficits have become a central force behind rising corporate earnings and elevated stock market valuations.

In a recent analysis, Chris Brightman—partner, senior advisor, and board member at Research Affiliates—and Alex Pickard, the firm’s senior vice president for research, examined the historical connection between government deficits and the way those funds ultimately lift asset prices.

They observed, “In today’s financialized U.S. economy, every dollar spent through deficit financing can translate directly into a dollar of corporate profit.”

Currently, annual deficits have ballooned to $2 trillion, with interest payments on the debt alone reaching $1 trillion. As government expenditures outpace tax revenues, the Treasury is compelled to issue increasing amounts of bonds.

Research Affiliates notes that much of the capital raised through government borrowing ends up in consumers’ hands, mainly via entitlement programs, which in turn bolster corporate profits.

However, for many years, corporations have largely refrained from using these profits to expand operations. Fierce international competition—particularly from China—has kept domestic returns low, and most investments have simply replaced aging assets rather than growing capacity.

Consequently, companies have funneled much of their excess capital back to shareholders through dividends and stock buybacks. These funds often flow into passive investment vehicles that purchase stocks regardless of price, further inflating market valuations.

Brightman and Pickard explained, “Because these funds are required to stay fully invested, they channel new inflows into buying stocks based on market capitalization, without regard for underlying value, which drives prices higher even if fundamentals remain unchanged.”

Historical Evidence: The 1990s Surplus

The authors highlighted a real-world example supporting their argument: In the late 1990s, the U.S. briefly eliminated its budget deficit and even ran a surplus. This was achieved as a booming economy boosted tax receipts and welfare spending was curtailed. During this period, corporate profits also declined.

This pattern, they warn, has made financial markets more vulnerable, as corporate earnings have become increasingly dependent on government deficits rather than private sector investment.

Brightman and Pickard cautioned, “A shift toward a healthier economy—marked by shrinking deficits and increased net investment—could sharply reduce both corporate profits and stock valuations, potentially triggering a financial crisis with severe political fallout.”

Fragility in the U.S. Debt Market

Despite increased tariff revenues during President Donald Trump’s administration, the national debt continues to mount, prompting warnings from financial leaders such as JPMorgan CEO Jamie Dimon and Bridgewater Associates founder Ray Dalio.

Trump has also proposed a 50% increase in defense spending, raising the annual military budget to $1.5 trillion and further expanding the debt burden.

Over the past decade, the profile of U.S. debt holders has shifted significantly, with private investors now holding a larger share and foreign governments reducing their exposure.

Geng Ngarmboonanant, a managing director at JPMorgan and former deputy chief of staff to Treasury Secretary Janet Yellen, warns that this shift could make the U.S. financial system more susceptible to instability during market turbulence.

He noted that foreign governments held over 40% of U.S. Treasuries in the early 2010s, up from just above 10% in the mid-1990s. This dependable investor base allowed the U.S. to borrow at low rates. Today, foreign holders account for less than 15% of the Treasury market.

Other Growth Drivers and New Competition

While federal deficits play a major role, they are not the sole engine of economic growth. The rapid expansion of artificial intelligence has unleashed a wave of investment in semiconductors, data centers, and building materials.

Yet, major AI companies are also tapping the bond market to finance annual spending in the hundreds of billions, increasing competition for investors with the Treasury, which must continually find buyers for new government debt.

According to a recent note from Apollo Chief Economist Torsten Slok, Wall Street expects investment-grade bond issuance this year to reach as much as $2.25 trillion.

Slok questioned, “With hyperscalers issuing so much debt, who will step in to buy these bonds? Will it draw demand away from Treasuries, pushing up interest rates? Or will it divert funds from mortgages, raising mortgage spreads?”

This article was originally published on Fortune.com

“Ironically, the easier path may be to continue as we are until a financial crisis forces the discipline we have so far avoided.”