The gentleman’s not for turning. That’s what Donald Trump says, at least. August 1 was always the deadline. And countries that don’t make a deal with the US will get blasted with century-high tariffs.

Markets don’t believe him. On Tuesday, Trump warned of draconian 50% copper levies and 200% import taxes on pharmaceuticals and markets barely moved. The S&P was down a miniscule 0.07%. The Nasdaq 100 actually gained.

This market complacency looks dangerous to me, especially since blue-chip US equities are overvalued based on traditional metrics. But the real threat is that tariffs could crush financially fragile smaller businesses. No one’s talking about that. And that risk isn’t captured by the S&P 500. So let’s spend this newsletter unpacking the issue.

• Hyman Minsky, whose dictum “Stability breeds instability” predicted the 2008 Great Financial Crisis, showed us that a larger share of fragile economic agents makes the overall economy more vulnerable to shocks (like an unexpected increase in tariff rates).
• Without that financial fragility, we’re looking at a garden-variety downturn that long-term investors might be able to ignore. But fragility can bring financial distress that will dramatically lower valuations in a downturn.
• Despite the high valuation multiples of companies in the S&P 500, the funding of their operations look comparatively secure. It’s the smaller firms that are insecurely financed and present the greatest threat to employment and to worsening a downturn which would also take down stocks. 

Ponzi financing has increased dramatically. Investors are chasing the next Amazon.com

Let’s start with this chart.

It’s from a slide deck presented at a panel discussion I recently moderated, from Leila Davis, a professor of economics at University of Massachusetts Boston. She’s an expert in the economics of profitability, financialization, and financial fragility, which means she studies corporate profitability, its sources and its sustainability. And her chart shows that, increasingly, publicly listed US companies have ‘Ponzi’ financing regimes.

Translation: investors have become increasingly comfortable buying shares of companies that can’t fund themselves out of their own cash flow.

Why is that, you might ask? I believe a lot of it has to do with the proven Silicon Valley model. It’s Apple. It’s Microsoft. It’s Amazon. Start an innovative company in your basement with some seed capital. Then, get more funding from venture capital firms once your idea becomes promising. Finally, go public, still sporting ridiculous growth rates. These companies have proven themselves as core holdings in baskets of US stocks. Therefore, people are willing to overlook Ponzi financing of smaller public companies, regardless of sector, as they wait for profits to gush out when the companies reach scale.

By the numbers

It ‘s not the S&P 500 with financial fragility

In another one of Dr. Davis’ slides, you can see that Ponzi financing remains rare among big firms, but in the bottom quartile of public companies, there’s been a dramatic rise in those that can’t finance their operations out of cash flow.

In the Minsky framework, a company is considered to have hedge financing if expected cash flows exceed interest and principal payments. They’re speculative when they need to roll over principal payments. Ponzi is when you can’t fund your business without an influx of new money. SpaceX is an example of a business considered successful that is operating in Ponzi. It’s now raising money to fund operations at a valuation of $400 billion.

It’s hard to fight the received wisdom — that Trump won’t follow through on his threats because he’s afraid of the consequences — when that thinking has recently driven US equity markets to record highs. Still, it’s disconcerting.

I mean, even if you can rule out worst-case scenarios, the economy can still get wrecked by the drip-drip of threats and the uncertainty of it all. After all, copper prices rose the most since 2008 on the 50% tariff news. That price increase gets passed through to all manner of manufactured products.

If that constant uncertainty and whipsawing of prices finally brings the US economy to a standstill, there’s a non-zero risk — I’d call it substantial — that investors’ willingness to fund firms with operating budgets that exceed cash flow would diminish swiftly and substantially.

It’s not that the Silicon Valley model is going away. It’s wildly successful. And Dr. Davis’ research shows this isn’t just a tech play. She says Ponzi structures have grown across sectors of the US economy in response to that success. Still, to the degree investors husband their cash more tightly due to a downturn in growth, you will get a knock-on effect that hurts small listed companies. The majority of them can’t fund operations from cash flow and will, thus, be forced to cut capital investment and lay off staff.

What does that mean for big firms and the economy? My view is that it’s akin to what we saw when the Internet bubble popped. Many a small internet companies and upstart telecom businesses went bust. The accompanying wave of job losses and the evaporation of capital investment helped tip the US economy into a recession. It also reduced earnings multiples for publicly-traded companies large and small. The double whammy of lower profits and lower profit multiples meant excruciating losses.

Many of these companies would have been viable without the withdrawal of funding. Internet startup Webvan crashed and burned in that downturn despite the fact that versions of its business model have proven wildly successful for Walmart, Instacart and Amazon. It’s just that, when the cash flow stops, you have to be able to fund yourself from operations or go out of business.

Between 2001 and 2010, the percentage of small businesses with negative operating cash flow declined. The percentage was still high, but it fell as investors became more discerning. That’s the risk this time as well.

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One housekeeping note. Until this year I hadn’t been active on social media for a long time. But I now post often on Bluesky. Follow me there at @edwardnh.bsky.social.

Things on my radar

• This Bloomberg piece from the editorial board on deficits is worth reading.  It points to deficits that are "7% of GDP even if the economy remains at full employment." That's the problem: scarce economy-wide resources being used on what I consider a lower-quality resource allocation. It’s a recipe for inflation.
• Here’s another one I liked on Powell’s successor. Basically, one person won’t be enough to remake the Federal Reserve the way Trump wants to. Wouldn’t it be wild if the Fed turned out to be the one institution Trump found most difficult to bend to his will?
• The last link is this innocuous one on Goldman Sachs trying to prevent talent fleeing to private equity. For me, it’s reminiscent of investment banks competing with Internet companies in the late 1990s. The fact that Goldman is demanding an oath of allegiance strikes me as peak private equity. 

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