What Is the Investment Impact of Our Federal Deficit?

By Larry Swedroe

One of the widespread concerns I keep getting asked about is the impact of our federal deficit on investments. A new study by Marlena Lee of Dimensional Fund Advisors demonstrates that the impact isn’t what you would think.

Before we discuss the study, it’s important to note that the fact that our deficit (and the resulting debt) is a major problem is just that — a piece of information and nothing more. What you have to understand that it’s not information you should use to alter your investment plan. The reason is that if you know the information (and it’s not insider information), you can be 100 percent sure the big institutional investors that do most of the trading and therefore set prices also are aware. Thus, that information (and the risks it brings) is already embedded in prices.

It’s critical to understand that it doesn’t matter if news is good or bad, only if it’s better or worse than already expected. We see this all the time when a company reports earnings down 20 percent (clearly a bad number), yet the stock price increases because the market expected an even worse figure. The reverse is true when there is good news, but the stock price falls because the news wasn’t as good as expected.

Federal Deficits and Debt
We begin by noting that the U.S. — with a debt-to-GDP ratio of about 90 percent — isn’t the only major industrial country with a deficit/debt problem. The 28 countries in the Organization for Economic Cooperation and Development have debt-to-GDP ratios ranging from 23 percent (Australia) to 199 percent (Japan), and more than half the countries have deficits in excess of 70 percent.

Interest Rates
In her study “The Economics of Fiscal Deficits,” Lee concluded that today’s deficits don’t provide us with valuable information about either future yield curves or future bond returns. In other words, today’s interest rates already incorporate information about fiscal policy.

Economic Growth
It turns out debt has very little impact on economic growth until it exceeds 50 percent of GDP. However, even at as much as 70 percent of GDP, debt levels only explain about 12 percent of the variation in GDP growth.

Equity Returns
While deficits/debt negatively impact economic growth, there’s actually a negative relationship between a country’s growth rate and its stock returns. The explanation is similar to the reason value stocks produce higher returns than growth stocks despite producing much lower growth in earnings: Markets don’t price growth, they price risk!

For developed MSCI countries from 1971 through 2008:

• High-growth countries (average real growth of about 1 percent) produced equity returns of 12.9 percent
• Low growth countries (average real growth of about -4 percent) produced stock returns of 13.5 percent.

For emerging market countries from 2001 through 2008:

• The high growth countries (average real growth of about 2.5 percent) returned 19.8 percent
• The low-growth countries (average real growth of about -5 percent) returned 24.6 percent.

Remember this the next time you are tempted to jump on the China or Brazil bandwagon.

While the talking heads from Wall Street and the financial press continue to produce dire forecasts based on the deficits, the historical evidence demonstrates that today’s deficits and debt levels don’t provide any valuable information about the future returns to either stocks or bonds. Thus, you should stick to your well-thought-out plan and ignore the noise designed to get you to act when doing nothing is in your best interests.