Federal Deficit and Stock Returns
Posted in Economic Indicators
August 1, 2011
Does the level of the U.S. federal deficit systematically influence stock returns, perhaps by stimulating consumption and thereby lifting corporate earnings (bullish) or by igniting inflation and thereby elevating discount rates (bearish)? To check, we compare stock returns to the deficit (receipts minus outlays) as a percentage of Gross Domestic Product (GDP). We align stock returns with deficit calculations (federal fiscal years) as follows: (1) prior to 1977, we calculate annual returns from July through June; (2) we ignore the July 1976 through September 1976 transition quarter; and, (3) since 1977, we calculate annual returns from October through September. Using fiscal year deficit data and fiscal year returns for the Dow Jones Industrial Average (DJIA) during the 81-year period 1930-2010 (with 2010 estimated), we find that:
The following chart relates the fiscal year change in DJIA to the same-year federal deficit as a percentage of GDP over the entire sample period. A positive “deficit” means a surplus (receipts exceed outlays). The Pearson correlation between the two series is -0.14, and the R-squared statistic is 0.02, indicating that annual variation of the deficit as a percentage of GDP explains just a very small portion of variation in contemporaneous stock market returns. In other words, increasing the deficit may slightly stimulate the stock market.
The three outliers to the left side of the distribution come from World War II (fiscal years 1942-1945). Excluding 1942-1945 has little effect on correlation and R-squared. The outlier at the top of the chart is fiscal year 1933, for which the DJIA return is 129%. Excluding 1933 has little effect on correlation and R-squared.
For a different perspective, we look at quartiles of annual deficits.
The following chart summarizes average fiscal year DJIA returns by quartile of deficits as a percentage of GDP over the entire sample period. The “Contemporaneous” average returns are for the same fiscal year as the deficits, and the “Following Year” returns are for the fiscal year after the deficits. Quartile subamples are small, with only about 20 observations each.
Much of the very large returns for the “Biggest Deficits” quartile comes from inclusion of the 129% return for 1933. Excluding 1933 reduces the “Contemporaneous” average return for this quartile to 8.8% and the “Following Year” average return to 11.8%. Excluding 1933 and 1942-1945 reduces them to 8.7% and 9.5%, respectively.
Might deficits reliably lead stock returns?
The final chart summarizes correlations between DJIA fiscal year returns and fiscal year deficits as a percentage of GDP for various lead-lag relationships over the entire sample period, ranging from stock returns lead deficits by four years (-4) to deficits lead stock returns by four years (4). Correlations are generally small. As from the quartile perspective, there is some reason to believe that large deficits tend to be good for stock returns for the same fiscal year and the following fiscal year.
Other business cycle factors could be confounding the relationships.
In summary, evidence from simple tests offers weak support (subject to great variability) to a belief that big federal deficits are good for stock returns for the same fiscal year and the next fiscal year.
Cautions regarding findings include:
- Given the large variability in stock market returns and deficits, sample and subsample sizes are small.
- Variable distributions may not be tame (normal-like). To the extent they are wild, interpretations of simple statistics break down (as indicated by the large effect of 1933 in the quartile breakdown above).
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