Estimates from the bi-partisan Congressional Budget Office indicate the federal budget deficit will rise to $1.5 trillion in 2010 before falling to $1.3 trillion in 2011, representing 10.3% and 8.9% of estimated Gross Domestic Product (GDP), respectively. This raises a key question for investors: What impact might massive government spending have on stock market returns? Stated a different way, are stock market returns systematically linked to the federal government’s budget? An examination of the historical relationship between stock market returns and the federal budget yields what may be considered a counterintuitive result.
Our historical measure of stock market returns is the annual performance of the S&P 500 Index since 1930. The measure for government spending is the annual budget deficit/surplus since 1930 as a percentage of GDP (as reported by the Office of Management and Budget).
Performing a mathematical regression of the S&P 500 returns against the federal budget as a percentage GDP produces this accompanying chart. The R2 statistic displayed is a measure of “goodness-of-fit” for the regression equation on the data, or more specifically, how closely the blue data points surround the bold black line ranging from left to right. This statistic details the percentage of the variation in stock market returns that can be explained by the variation in the federal budget as a percentage of GDP.
Interestingly, the analysis shows that just 3.8% of the variation in stock market returns is explained by the annual variation in the federal budget. This suggests little to no direct relationship between the level of government spending and equity returns in any given year.
Taking a different perspective, we can examine average equity returns in the years immediately prior to and following federal budget decisions to further understand the relationship of stocks returns and government spending.
The second accompanying chart divides the past 80 years of government spending into deciles and examines the average market return in each of three years: the same year of the budget deficit or surplus, the year prior and the year following. Perhaps surprisingly, we find that stock market returns on average are higher in the years corresponding to and surrounding large budget deficits. For instance, the eight largest annual deficits on record ranged from 5.9% of GDP in 1934 to 30.3% of GDP in 1943 (including 9.9% of GDP in 2009). For this top decile of largest deficits, the average annual return of the S&P 500 Index in the same year is 18.9%, 18.1% in the year following and 22.4% in the year prior – impressive results considering the average annual return on the S&P 500 is 11.4% through the end of 2009.
On the opposite end of the spectrum, the eight smallest deficits (including surpluses) reflected in the tenth decile are associated with average annual market returns of 9.9% in the same year, 5.7% in the year following and 8.4% in the year prior. This data might suggest that budget deficits actually lead stock market returns, perhaps supporting famous British Economist John Maynard Keynes’ theory for deficit spending during recessionary cycles to increase business output, incomes and consumer spending.
In conclusion, though the long-term economic costs of an unsustainable budget deficit are real, it does not necessarily follow that the federal budget explains near-term stock market returns with any significance. Future government policy and economic growth are unknowable and investors should be hesitant to adjust their portfolio allocation in the face of projected political or fiscal events. A disciplined reliance on a globally diversified portfolio continues to be the best defense against this inherent uncertainty.
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