Deficits, Debt and Markets
As government spending hits record levels around the globe, some politicians, economists and pundits are warning that rising indebtedness may drag down economies and financial markets. This issue has raised concern among investors who assume that a government’s fiscal policy is closely linked to the country’s economic growth and market returns.
The concern is understandable. Over half the Organization of Economic Co-operation and Development (OECD) member countries expect to have 2010 debt-to-GDP levels above 70%—and the US, Canada and the UK project debt levels exceeding 80% of their 2010 economic output.
Government efforts to stimulate their economies out of recession may partly explain this level of borrowing, which is high compared to historical levels. But longer-term trends such as aging populations, expanding public pensions and rising health care obligations are compounding the fiscal challenges of these countries.
Global investors may be particularly concerned about the economics of government spending in countries around the world. So how does public debt affect economic growth and market returns? The evidence might surprise you. Although rising levels of government debt create headwinds for economic growth, a country’s deficit and debt levels do not seem to adversely impact capital market returns.
Let’s explore these issues by addressing a few popular questions about sovereign debt:
Do rising deficits drive up interest rates?
Yes. As borrowing increases, a government must offer higher interest rates on its debt to compete for capital. The public sector consumes savings and investment that may have otherwise fueled private sector growth—a displacement of resources known as the “crowding-out effect” in economic theory. Additionally, as debt levels rise, market concerns about higher default and inflation risks put additional upward pressure on interest rates.
Consistent with this theory, research shows that current interest rates reflect expectations of future deficits but that current government deficits and debt do not predict future interest rates or bond returns. So, long-term interest rates rise when the market expects future deficits to increase. However, today’s interest rates and bond prices already reflect information about current government spending, and markets quickly incorporate new information.
Do higher deficits hamper economic growth?
It depends on a country’s debt level. Using World Bank data from 1991 to 2008, a comparison of current deficits to future GDP growth in 67 countries found an increasing interactive effect between deficits, debt and economic growth. High-debt countries that run deficits are more likely to experience lower economic growth over the next three years. But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation in future GDP growth. The combination of high debt and deficits can create headwinds for economic expansion, but slower growth is not guaranteed.
So investors are justified in having some economic concern about higher government spending and borrowing. But the impact on investment returns is less clear. Let’s now consider the potential effect on equity markets.
Does low economic growth result in diminished equity returns?
No. This relationship can be tested by comparing a country’s GDP growth to its equity market performance in subsequent years. In an analysis using all the developed countries in the MSCI universe, markets were divided each year from 1971 to 2008 into high-growth and low-growth “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.
Applying the same methodology to the MSCI emerging-market countries shows an even greater return difference, although the data period is much shorter (2001 to 2008). Other research has confirmed a weak relationship between a country’s economic growth and its stock market returns. Several factors may contribute to this decoupling effect. For one, with globalization, a multinational company’s stock price in its home market may not reflect economic conditions in other countries. Also, the fruits of economic growth do not accrue exclusively to public companies, but also to income earners, non-public businesses and private investments.
Finally, consider that risk, not economic growth, determines a stock’s expected return. Research indicates that this principle also applies to a country’s stock market. Similar to value and growth stocks, markets with a low aggregate price (relative to aggregate earnings or book value) have high expected returns, and markets with a higher relative price have lower expected returns. Consequently, while holding a “growth market” may be a rational investment approach, investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected GDP growth.
Do fiscal deficits lead to currency depreciation?
Not necessarily. It is commonly believed that large fiscal deficits and high debt cause a currency to depreciate as the government borrows more from foreign sources and investors concerned about inflation and default risk flee the currency. Although recent developments in the US would seem to support this relationship, there is less convincing long-term evidence that deficits affect currency rates. During the 1970s and 1980s, the dollar strengthened while the government increased deficit spending. This observation is consistent with academic studies concluding that exchange rates appear to move randomly, and there are no models to date that can reliably forecast currency returns.
Some economists claim that developed market countries are moving into an era of high government deficits and lower market returns. While higher deficits and debt may impact a nation’s interest rates and economic growth to some extent, the investment implications are not easily discerned. History does not offer strong evidence that current deficits predict future bond or equity returns in a country’s financial markets or anticipate short-term currency movements.
Investors should assume that stock and bond prices reflect all that is currently known and expected about government spending and debt, economic growth, risk and other issues affecting performance.