March 29, 2010As investors have gained confidence that the financial markets have healed substantially and that the economy has begun recovering, their concern has turned increasingly to the flow of federal red ink. Though not all deficits, history shows, lead to bad markets, there is nonetheless reason for concern. The White House itself forecasts huge budget shortfalls for years to come, and it has failed so far to offer a credible plan to change that outlook. What deficit-narrowing plans it has offered focus almost exclusively on tax increases. Still, though the fiscal situation looks deeply problematic, other considerations— economic growth, a balanced monetary policy, earnings improvements, included—may well allow stocks to rise even in the face of fiscal woes.
Table 1 lays out the relevant statistics. It tabulates market responses to the five worst deficit events and the five best surplus events. It focuses on the most extreme year of each event, and uses the S&P 500® Index1 to measure stock price movements one year and three years following. On average, the figures clearly suggest that the market does better in response to surpluses than to deficits, but the picture is hardly uniform. Sometimes, the market does well after large deficits, as in the three years following the large 1983 and 1992 deficits. And sometimes, it does not do so well even after a surplus, as in the three years following 2000. Clearly, a lot more is at work than just the flow of red ink. The state of the economy and interest rates, obviously, have independent effects. History also makes clear that much also depends on whether deficits are widening or narrowing. It also matters whether the deficits resulted from high spending or low taxes. Here is a descriptive look at some of this evidence:
After the huge deficit of 1946, the market had only a limited response. Investors no doubt saw the red ink purely as the reflection of a war that they also knew had ended. They, no doubt, saw the surplus of 1948 as equally aberrant. The good market returns that followed had a lot more to do with the postwar recovery than any budget considerations.
But fiscal considerations surely had much to do with the market shortfalls following the 1968 and 1976 deficit highs. Unlike in earlier years, budget problems in these cases persisted for years after these deficit highs. Of course, markets also suffered at the time from an accelerating inflation and high interest rates, both of which depressed equities and neither of which was exclusively a product of the deficits.
Market progress after the large deficits of 1983 and 1992 no doubt reflected strong economies and also a growing confidence that these deficits were not as chronic as originally expected. In the first instance, the market also got a lift, despite budget concerns, from falling oil prices and declining interest rates. The improving economy also brought the deficit down from 1983’s high at 6.0% of gross domestic product (GDP) to about 3% by 1987—still high, but half of what it had been. In the second instance, the fast growing economy and the end of the Cold War closed the budget gap of nearly 5% by more than half, to barely 1.5% of GDP by 1996.
For those who seek an explicit historical model, none of these previous experiences offers an especially good fit for today’s situation. Unlike the times following wars, the country today cannot look for a peace dividend to close the budget gap. Unlike the 1980s and 1990s, growth prospects, especially with tax hikes in prospect, are far from robust enough to staunch the flow of red ink as quickly as then. But budget policy aside, the market will get help from the economic and earnings recovery. The proposed tax increases doubtlessly will slow economic growth, but not stop it. What is more, investors are probably seeing the worst deficit picture now. Even modest economic growth will tend to narrow the budget gap, so that investors, over time, will see better if not necessarily good budgets.
Milton Ezrati, Partner and Senior Economist and Market Strategist, has been widely published in a wide variety of magazines, scholarly journals, and newspapers, including The New York Times, Financial Times, The Wall Street Journal, The Christian Science Monitor, and Foreign Affairs, on a broad spectrum of investment management topics. Prior to joining Lord Abbett, Mr. Ezrati was Senior Vice President and head of investing in the Americas for Nomura Asset Management, where he helped direct investment strategies for both equity and fixed-income investment management.
The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.
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