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.
Over half the Organization of Economic Co-operation and Development (OECD) member countries expect to have debt-to-GDP levels above 70%. The US, Canada and the UK project debt levels exceeding 80% of their economic output.
Global investors may be particularly concerned about the economics of government spending in countries around the world, and government efforts to stimulate their economies out of recession may partly explain current 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.
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.
Investors are justified in having some economic concern about higher government spending and borrowing, but the impact on investment returns is less clear. This relationship can be tested by comparing a country's GDP growth to its equity market performance in subsequent years. Dimensional Fund Advisors recently conducted an analysis using all the developed countries in the MSCI universe, divided each year into high-growth and low-growth "portfolios" based on growth in real GDP. The results showed that 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.
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?
No. 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 who are concerned about inflation and default risk flee the currency. And although recent developments in the U.S. 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 that there are no models to date that can reliably forecast currency returns.
Conclusions
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.
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.
Today's interest rates reflect expectations of future deficit levels. The DFA 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.
MSCI Barra Research Bulletin, "Is There a Link Between GDP Growth and Equity Returns?" May 2010.
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. 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).
