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Wednesday, December 15, 2010

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 graph below shows the projected state of indebtedness around the world.1 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 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, our analysis shows that current interest rates reflect expectations of future deficits2 but that current government deficits and debt do not predict future interest rates or bond returns.3 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, 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 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. We conducted this 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. 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.
The graph below illustrates this relationship in terms of a dollar invested in high- 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 confirmed a weak relationship between a country’s economic growth and its stock market returns.4 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.5 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. 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.6 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.7
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.

Endnotes:
1.  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.

2. Today’s interest rates reflect expectations of future deficit levels. The 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.

3. Today’s deficits do not predict tomorrow’s interest rates or bond returns. Regression results show that current deficits do not reliably predict changes in the five-year US Treasury yield spread (1982 to 2009) or future bond returns (1947 to 2009). Data source: Federal Reserve Bank of St. Louis.

4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.

5. 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. Their research uncovered strong parallels between the explanatory power of aggregate book-to-market and aggregate earnings-to-price ratios for country stock markets.
6. Another common assumption is that current account deficits and currency appreciation are related. (The current account balance is the difference between a country’s receipts and payments to the world. This account is composed mostly of the balance of trade, with net income and foreign aid playing a smaller role.) Academic research yields equivocal results on whether this relationship holds.
7. 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).

Pennsylvania Physician Advisors, Inc. is an investment advisor registered with the Pennsylvania Securities Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

Tuesday, December 7, 2010

Why Irish Eyes Aren't Smiling

Reaching understanding on the right way to invest often starts with studying bad investment decisions. But the lessons are far less painful when they are built on others’ experiences.

Recent events in Europe provide case studies on what can go wrong when a wealth-building strategy is built on too much debt, too little diversification and too little awareness of risk.

Ireland in recent years, for whatever reason, became heavily dependent on a couple of industries – namely construction and banking. The IMF1 in a report this year described the causes of these imbalances as “rapid credit growth, inflated property prices and high wage and price levels”.

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Now, an economy is clearly much more complex than any individual and the ability of governments to control the composition of growth is limited. But there still are lessons here for individuals if they fail to spread their wealth-building strategies across different asset classes and diversify within those asset classes.

Becoming more diversified leaves you less open to idiosyncratic risks that are related to one sector or one company or one asset class. And you can do this without significantly compromising your expected return.
Another lesson from Ireland is not to base your investment strategy only on what happens during the good times or only in the bad.

Real interest rates in Ireland were very low before the crisis, which encouraged people to load up on debt. That debt now has to be repaid in an environment of falling prices, higher real interest rates and sluggish growth. The problem was too much focus on return and not enough on risk.

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For individuals, the take-out is that leverage, while increasing the potential upside in boom times, magnifies the downside in the bust. So people swing from greed to fear and back again.

A better approach is to have a realistic, measured and long-term approach to risk. This means that during rising markets, you don’t take on more risk than you originally intended. And it means that during falling markets, you don’t become more risk averse than you first planned.

A third lesson is the importance of liquidity. This means you can quickly turn your investments back into hard cash if you need to.

Ireland’s banks got into trouble because their loan portfolios were dominated by speculative property ventures. When the crisis hit, their recourse to short-term funding dried up and they were unable to call in loans because of the illiquid nature of the assets.

For individuals, the lesson is there is value in having portfolios with sufficient liquidity. That means publicly traded equity and fixed income securities that can be turned into cash if needed.

So Ireland has some lessons for all of us:

• Holding concentrated portfolios exposes you to risks you don’t need to take. Diversification is the answer, both across and within asset classes.

• Basing your strategy only on the good times means you can end up taking more risk than you intended. And grounding your strategy only on the bad times means you can miss real opportunity. A balanced approach to risk and return is the answer.

• Finally, staking everything on illiquid assets can leave you high and dry when you need quick access to cash. So keep a proportion of your portfolio in liquid investments.

• All these strategic decisions are ones you should make in consultation with an advisor who understands your risk appetite, personal situation and goals.

Just don’t count on the luck of the Irish.


1. IMF Country Report No 10/209, Ireland, July 2010