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Government Debt and Your Portfolio’s Rate of Return
The US federal debt level has gone from high to higher after the economic stabilization actions taken by the federal government in the wake of the financial crisis. How might you expect this increased federal debt will impact interest rates, economic growth – and most importantly – the return on your portfolio?
Spending has hit record levels by governments around the world. Some politicians, economists and pundits are warning that these rising debt levels will drag down economies and financial markets. This issue has raised concern for many investors who assume that a government’s fiscal policy is closely linked to its economic growth and market returns. This “conventional wisdom” deserves a closer look, however – and we do that in this article.
It is an obvious and uncomfortable fact that many economic stabilization actions taken by the US government in the aftermath of the financial crisis have significantly increased the federal debt level. The problem of rising public debt is not a US-only problem. Spending has hit record levels by governments around the world. Some politicians, economists and pundits are warning that these rising debt levels will drag down economies and financial markets. This issue has raised concern for many investors who assume that a government’s fiscal policy is closely linked to its economic growth and market returns. But how are government debt levels actually related to economic growth and market returns in those countries? The results are surprising and non-intuitive.
First, just how indebted are countries around the world? The graph below shows the projected state of indebtedness around the world. Over half the Organization of Economic Co-operation and Development (OECD) member countries expect to have debt-to-GDP levels above 70% – and the US, Canada, and the UK project debt levels exceeding 80% of their economic output.
Government efforts to stimulate these 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 for 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.
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.
Do higher deficits hamper economic growth?
Possibly. It seems to depend on a country’s debt level. Using World Bank data from 1991 to 2008, we compared current deficits to future GDP growth in sixty-seven countries and 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 of higher debt levels on equity market returns.
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. Using all of the developed countries in the MSCI universe, we divided them each year into “high-growth” and “low-growth” portfolios based on that year’s growth in real GDP. Over time, it turned out that there was no statistical difference between the annual equity market returns of high-growth and low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.
The graph on the following page illustrates this relationship in terms of a dollar invested in high-GDP versus low-GDP growth portfolios from 1971 to 2008. The low-GDP growth portfolio’s higher annual return would have generated slightly more wealth for the period. The chart details the average annual return and real GDP growth for both groups.
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). The return of the high-growth country portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the low-growth portfolio (-4.94% GDP growth). Other research has also pointed to a weak relationship between a country’s economic growth and its stock market returns.
What factor might contribute to this decoupling effect? Consider a theme that we often make – that value, not economic growth, is a major determinant of a stock’s expected return. Research has indicated that this principle may also apply 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. Investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected GDP growth.
Some have claimed that many developed market countries (the US included) are moving into an era of high government deficits, lower economic growth and therefore 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 understood.
