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How Do Deficits and Debt Interact With Equity Markets?

With government spending at record levels worldwide many political leaders, economists and analysts are cautioning that global markets and economies could be hamstrung by the rising tide of government debt. Many investors are now concerned as they believe a government’s fiscal policy is closely tied to the country’s economic performance and market growth.

The following chart shows the projected level of debt for Organization of Economic Co-operation and Development (OECD) countries for 2010.1 More than half the OECD member countries are expected to have debt-to-GDP levels above 70% with the US, UK and Canada projected to have debt levels matching over 80% of their countries’ economic output.
Government attempts to spend these economies out of recession may explain such historically high levels of borrowing. However, overriding trends like the increasingly older world population, the increasing healthcare costs that come with it and growing public pensions are adding to the challenges of these countries’ fiscal policies.

Investors are fearful of the results of large scale government spending across the globe. So how are economic growth and financial markets returns affected by governments’ large debt position? The facts might surprise you. While increasing government debt levels make it tougher for economic growth, a country’s budget shortfall and debt levels appear to have a minimal impact on capital market performance.

The following drills down deeper into these issues by examining several of the common questions about sovereign debt:

Do growing deficits drive up interest rates?
Yes. As a country borrows more and more it must offer investors a higher interest rate to compensate the investors for the risk they are taking investing in a more levered borrower. With increasing debt levels the risk of default increases and worries over inflation combine to augment investor demand for still higher interest rates. Meanwhile, the money lent to governments eliminates the chance for these funds to be used to drive growth in the private sector.

In line with this premise, an analysis shows that future deficit expectations are reflected in current interest rates,2 but the debt and deficit level that the government currently has does not forecast future interest rates or fixed income performance.3 While, long-term interest rates increase when the market expects future deficits to rise, current interest rates and bond prices already include information about existing government spending and markets quickly assimilate any new data.

Do greater deficits hinder economic growth?
The answer to this varies based on the country’s indebtedness. Looking at World Bank data from 1991 to 2008, we compared current deficit to future GDP growth in sixty-seven countries and found an increasing inter-relatedness between debt, deficits and economic growth. Countries that continue to maintain high deficits and heavy debt are more likely to achieve weaker economic growth over the following three years. However, there are many factors that determine a country’s’ economic direction and deficits explain just a fraction of the variation in future GDP growth. While a heavy debt burden and running a deficit can impede economic expansion it does automatically result in slower growth.

There is some evidence that investors should be concerned about high government borrowing and spending, but their effect on investment performance is not clear.

Are equity returns hurt by light economic growth?
We can look at this relationship by comparing a country’s GDP growth to its equity market performance in succeeding years. We looked at all developed countries in the MSCI universe and separated every year into either high-growth or low-growth “portfolios” based on the country’s real GDP growth. The results showed that the annual returns of stock markets in high growth countries were not statically different than the returns in low growth countries and low growth countries actually had somewhat higher average returns.

The following chart displays shows the growth of $1 if it was invested in a high or low GDP growth country portfolios from 1971 to 2008. The low GDP growth portfolio would have resulted in having more wealth for the time frame. The chart lists the average annual return and real GDP growth for both sets.


If the same methodology is applied to MSCI emerging market countries an even larger discrepancy is found. The high growth country portfolio returned an average of 19.77% with positive GDP growth and the low growth portfolio returned 24.62% with negative GDP growth. The data covers a shorter period from 2001 to 2008, however.

Other studies have found a similar weak relationship between a country’s economic growth and its stock market performance.4 There are several issues that could lead to this divergence. With increasing globalization, a multinational company’s stock price could reflect its performance abroad, which might differ from its home market. In addition, the benefits of a country’s’ economic growth does not get perfectly passed to public companies. There are also workers private businesses and investment.

Lastly, it is risk and expected future cash flows that determine a stock’s expected return and, not economic growth. It has been shown that this relationship also exists for a country’s stock market.5 As with value and growth stocks, stock markets with a low aggregate price relative to aggregate earnings or book value have higher expected returns. Whereas markets with a high relative price have lower expected returns. Thus, by investing in markets that are expected to have high GDP growth, an investor should not anticipate higher performance.

Can currency depreciation result from fiscal deficits?
It is widely held that as governments run up deficits and increase their borrowing from global sources, their currency will fall. Investors, fearing inflation and potential default, seek to invest elsewhere. While current events in the U.S. might support this relationship, the long term picture shows a different story. In the 1970s and 1980s, the U.S. government raised deficit spending and yet the dollar strengthened.6, This evidence dovetails with academic studies that maintain exchange rates move indiscriminately and currently there are no financial models that can consistently project currency returns.7

With increasing government deficits, which are likely to exist for some time, there are economists claiming that developed countries’ markets will face lower market returns. Larger deficits and debt can possibly affect a country’s interest rates and economic growth, but their influences on market returns are not clear. Looking at historical evidence there is little support that short term currency depreciation and future bond or equity returns are predicted by current deficits.

Investors should assume that all public information regarding government spending and debt levels, economic growth, risk and other future expectations are reflected in current stock and bond prices.

1. The Organization of Economic Co-operation and Development (OECD) is an international economic organization of thirty-three countries founded in 1961 to stimulate economic progress and world trade. It defines itself as a forum of countries committed to democracy and the market economy.

2. Today’s interest rates reflect expectations of future deficit levels. The analysis compared five-year US deficit projections (as a percent of GDP) to yield spreads (five-year US Treasuries minus three-month US Treasuries) from 1992 to 2010. The yield spread increased 29 basis points for every one percentage-point increase in projected deficits. Data sources: Baseline projected deficits from the Congressional Budget Office; yields from Federal Reserve Bank of St. Louis.

3. Today’s deficits do not predict tomorrow’s interest rates or bond returns. Regression results show that current deficits do not reliably predict changes in the five-year US Treasury yield spread (1982 to 2009) or future bond returns (1947 to 2009). Data source: Federal Reserve Bank of St. Louis.

4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.

5. Clifford S. Assness, John M. Liew, and Ross L. Stevens, “Parallels between the Cross-Sectional Predictability of Stock and Country Returns,” Journal of Business 79, no. 1 (March 1996): 429–451. Their research uncovered strong parallels between the explanatory power of aggregate book-to-market and aggregate earnings-to-price ratios for country stock markets.

6. Another common assumption is that current account deficits and currency appreciation are related. (The current account balance is the difference between a country’s receipts and payments to the world. This account is composed mostly of the balance of trade, with net income and foreign aid playing a smaller role.) Academic research yields equivocal results on whether this relationship holds.

7. Richard A. Meese and Kenneth Rogoff, “Empirical exchange rate models of the seventies: Do they fit out of sample?” Journal of International Economics 14, no. 1 (February 1983): 3–24. Kenneth Rogoff and Vania Stavrakeva, “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting” (National Bureau of Economic Research working paper No. 14071, June 2008).

Raffa Wealth Management is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered personal investment advice.