Do Budget Deficits & Low Economic Growth Reduce Expected Investment Returns?

  • Research has shown that Government budget deficits and forecast economic growth as measured by Gross Domestic Product (GDP) are not reliable predictors of a country’s bond or equity market returns. 
  • Sharemarkets of countries that may have relatively low expected GDP growth in the medium term (such as the U.S) will not necessarily provide a lower return compared to countries with higher expected GDP growth, such as Australia.
  • In recent times, the stockmarkets of countries with low economic growth have marginally outperformed countries with higher economic growth. 
  • Research has also shown that large budget deficits do stifle long term economic growth. That is why many developed economies such as Germany and Britain are diligently attempting to reduce the size of their deficits.

Many investors are asking what happens when governments cease being the answer to our problems and start being the cause. Put another way, what are the implications for returns from the recent blowout in public sector debt around the world?

The diagram below illustrates the Organization for Economic Co-Operation & Development’s (OECD) 2010 projections for gross government debt and fiscal imbalances (i.e. present value of the difference between future debt and income streams).


Note: Most of Japan’s debt is held internally, which implies less risk of its debt being unloaded by investors. Therefore Japan’s debt level relative to other countries does not necessarily reflect its risk profile.

Whilst Australia’s public debt position is enviable at just 23% of Gross Domestic Product (GDP is the total market value of all goods and services produced by a country), speculation about the possible market consequences of expanding sovereign liabilities, particularly in Europe, the UK, Japan and the US, has been one of the major themes in markets this year and is never far from investors’ minds.

In many ways, these concerns are legitimate, as the diagram above raises questions about the sustainability of this burden and the consequences for future economic growth and returns from debt and equity markets. Many countries are facing ageing populations with social welfare and health costs certain to increase.

Whilst the global financial crisis is a contributor to growing public debt, it is not the only cause. Governments, particularly in southern Europe, have been so laggard about attending to fiscal imbalances that when a major shock arrived, their balance sheets were in no shape to cope (see information on Greece on page 6). These countries have limited scope to increase public debt without incurring substantial increases in the interest rate they must pay investors.

Pressures from the market, the International Monetary Fund (IMF) and central banks are forcing these countries to prune spending, adjust taxation and enact other reforms (such as increasing the retirement age) to repair their balance sheets and put their fiscal positions on a more sustainable footing. Germany and Britain are prime examples of countries taking firm steps to control public expenditure.

For those worried about the investment implications of widening public sector debt, it is helpful to reflect on a presentation attended by APW Partners on the economics of fiscal deficits[1].

The data presented clearly demonstrated that while the size of deficits and a nation’s future economic growth are correlated, current budget deficits are not a reliable predictor of either bond or equity returns.

The chart below compares the debt to GDP ratio for 27 OECD economies in 2000 with the total accumulated returns from those countries’ equity markets over the subsequent decade[2].


You can see that there is no statistically significant relationship between these two variables. As an example, Belgium had a very high debt-to-GDP ratio at the turn of the century of around 100% and very modest equity returns for the years 2001-2009. On the other hand, Italy had comparable public sector debt to that of Belgium 10 years ago, but its equity market was among the best performing in the OECD over the subsequent decade.

Another frequently asked question is that if debt-burdened economies are going to experience only modest economic growth for the coming period, should this be a reason to re-weight portfolios to other economies, such as Australia, that have low public debt and a potentially stronger growth profile. This is an important question as the growth paths of major global economies are becoming increasingly divergent.

Research shows no clear relationship between expected returns and GDP growth. In fact, over the period 1971 to 2008, low GDP growth countries achieved marginally higher equity market returns compared to high GDP growth countries.

Consequently, even if you could accurately forecast GDP for a country, this provides you with no radar to ascertain which countries are likely to outperform relative to others.

What this means for investors is that all known information is reflected in the price of securities, which has been and continues to be a cornerstone of APW Partners’ investment philosophy. It also suggests that the sharemarkets of countries that may have relatively low GDP growth in the medium term (such as the U.S) will not necessarily provide a lower return compared to high expected GDP growth countries, such as Australia.

Finally, there is no evidence that the size of public sector deficits is reliably related to subsequent returns on bond or equity markets. And while budget deficits do tend to stifle long-run economic growth, there is little demonstrated relationship between economic growth and market returns from one country to another.

In summary:

  • Budget deficits are related to higher long term interest rates
  • Large budget deficits may stifle long run economic growth
  • The size of budget deficits do not predict bond or equity returns
  • Low future economic growth does not imply low equity returns
  • The prevailing global economic climate alone does not necessitate changes to the target asset class allocations of investment portfolios.

[1] The Economics of Fiscal Deficits, Marlena Lee PhD, Dimensional Fund Advisors, September 2010. The findings of this report have been reinforced by research performed by Vanguard Investments

[2] Returns are net of dividends and are expressed in Australian dollars

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