If you’re like most of us, it’s hard to not keep an eye on how the U.S. economy is recovering from everything that’s happened since the start of 2020. However, it’s also easy to fixate on the gloomier economic indicators and try to interpret them as potential warning signs for the recovery and our portfolios. A popular one as of late is federal government debt, which reached a record $28 trillion in March. You might hear pundits and colleagues suggesting that this spells doom for the stock markets and your portfolio. Before making any rash decisions, let’s examine the relationship between federal debt and stock market performance.
One way to measure how efficient a country is at utilizing its debt is to compare that debt to its gross domestic product (GDP), which is the total value of goods and services produced in a single year. In the U.S., the ratio of outstanding government debt to GDP recently eclipsed 1, meaning that the value of outstanding debt is larger than the revenue stream produced by GDP. This has been the case before, but not since the end of World War II. The Congressional Budget Office projects that federal debt will be near double the GDP in 2050.1 And while all of this may be concerning to some investors, the historical relationship between debt-to-GDP levels and equity returns is far less worrisome.
In a recent study,2 Dimensional sorted the equity returns of countries into two categories: high-debt-to-GDP and low-debt-to-GDP. Interestingly, high-debt countries went on to outperform low-debt countries on average in both developed and emerging economies in the year following a high-debt rating. The study conducted the same analysis using a same-year timeframe for determining debt status and found that developed, high-debt countries still tended to outperform their low-debt counterparts on average, but slightly trailed low-debt countries in emerging economies.
Even though these results aren’t statistically significant—meaning that they aren’t strong enough to determine a causal relationship between debt-to-GDP levels and equity performance—we can draw some meaningful inferences from this study. First, it’s somewhat intuitive that countries with higher debt levels would generally produce higher equity returns. Countries with higher debt levels can be viewed as riskier and therefore would need to reward investors for taking that risk. But more importantly, we need to recognize that measures of national debt, GDP, and other macroeconomic data points are lagging indicators. They are pieces of information that once published are immediately absorbed into market prices. For this information to be valuable to you and me, we would need to be able to interpret that same information better than the collective markets and all their participants. And that’s extremely difficult, if not impossible. Therefore, while such information is interesting and perhaps worth knowing, it’s not valuable to our portfolios. This important distinction is often missed or ignored by those trying to act on it.
Regardless of whether this trend holds over time, your portfolio is dynamic and built to anticipate numerous economic scenarios by including a globally diverse set of stocks. And if you’re uncertain about the prospects for U.S. and international stock markets, that’s simply more reason to be globally diversified.
1. https://www.cbo.gov/publication/56977
2. https://www.dimensional.com/us-en/insights/under-the-macroscope-when-stocks-and-the-economy-diverge
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