In a previous article, I discussed the CBO’s projection for a 96% public debt to GDP ratio by 2028. It was the catalyst for a modest decline in stocks that afternoon. It’s a weird response because the deficit projections for the next 10 years have little impact on the hour by hour trading. Sometimes the market prices in events gradually instead of all at once, so it’s not easy to see what is happening on a day to day basis. The fact that the government is going to be facing budget issues in the long term isn’t news. However, there might be a sharp reaction at some point in the future when interest rates rise and the government has a tough time spending money on necessary items.
It’s possible that the current CBO projections aren’t affecting stock prices at all because investors wanting to take risk on stocks don’t have a choice when it comes to developed markets as most have high debt levels. It’s easy to come up with a country with a low debt level, but investing in one of them opposed to America isn’t a realistic choice because they are practically a different asset class. For example, India’s public debt to GDP was 52.3% in 2016 which is manageable. However, India is an emerging market which might not fit the needs of an investor considering developed countries.
The chart below shows the change in deficits per year in relation to the change in the stock market since 1959. The stock market has increased 15.5% annually when the deficit was more than $500 billion and when the government had a $100 billion or less deficit, the market went up about 6% per year. The chart shows the averages mask the fact that the relationship is uncorrelated. Performance depends on the business cycle. When the deficit is high, but shrinking, it’s a good time to buy stocks. Usually, when the deficit is relatively low, but increasing, it’s not a great sign. Using this guideline, it’s important to recognize that the deficits have been increasing over time. This means a high deficit compared to previous decades is actually low. Compared to the future deficits, the current one is probably low.