Blog - Investing Notes

January 3, 2006 – Update: Public Debt to Crush the Stock Market?

When the U.S. government runs a substantial deficit, we see commentary predicting the dollar's total inflationary debasement. We see other commentary that the deficit is no cause for alarm, because the United States can easily bear the current level of debt. Politicians (rhetorically) argue about reducing spending and/or increasing taxes to reduce the deficit. Does a large deficit (increase in public debt) drive down stock prices? Does it initiate a round of inflation that may drive stocks down later, per the calculations of our Real Earnings Yield Model? Using annual figures for the level of public debt from the Bureau of the Public Debt and S&P 500 index data since 1950, we find that:

The following scatter plot depicts the relationship between the annual change in the S&P 500 index and the annual change in the public debt since 1951. Out of 57 12-month periods (accommodating two changes in the federal fiscal year), the public debt increases 53 times and decreases four times. There is no visually obvious connection between change in public debt and stock prices. The Pearson correlation between these two series is only 11%, and the slope of a best-fit line is 0.39. These results indicate a very weak tendency for the stock market to react to changes in the level of public debt. The bottom line is that investors/traders should not give much weight to government deficit figures as trading signals.

We note, however, that the average change in the debt level for the ten best years for the S&P 500 index during 1951-2005 is 8.2%, above the overall average of 6.4%. For the ten worst years for the stock market, the average change in the debt level is 5.7%, slightly below average. Also, when the deficit grows at an above-average rate during 1951-2005, the average annual gain in the S&P 500 index is 10.6%, above its overall average of 9.3%. When the deficit grows at a below-average rate, the average annual gain for the stock market is 8.3%. These statistics suggest that an increase in the rate of government debt growth is modestly positive for the stock market.

But should not a rapid increase in public debt stimulate inflation as government borrowing strains capital markets? What is the long-term relationship between public debt growth and inflation? The next chart graphs both annual change in public debt and annual inflation (calculated using Consumer Price Index data from the Bureau of Labor Statistics) for 1951-2005. It appears that the rates of change in public debt and inflation move generally together for the first half of this period, but then diverged about 1980 when inflation fell sharply despite record rates of increase in public debt. It appears that some other factor(s) took control of inflation in the early 1980s. (The Federal Reserve Bank of San Francisco summarizes expert opinion on the rise and fall of the inflation peaks of the late 1970s in their weekly Economic Letter of July 7, 2000.)

The following scatter plot offers a closer look at the connection between changes in public debt and inflation since 1951 over two segments: 1951-1980 (green diamonds) and 1981-2005 (red squares). The Pearson correlation for the earlier segment is a moderately positive 49% (inflation tends to be high when the rate of debt growth is high). The slope of a best-fit line for 1951-1980 is 0.43, indicating that changes in pubic debt tend to have a moderate impact on the inflation rate. For 1981-2005, however, the correlation between changes in public debt and inflation is only 39%, and the slope of a best fit line is only 0.12. During this latter segment, inflation is generally under control and less sensitive to deficit spending by the government. Recent decades indicate, therefore, that the current above-average public debt growth rate means only a slight tailwind for the stock market per our Real Earnings Yield Model.

In summary, above-average growth in the public debt indicates: (1) slightly above-average concurrent performance for stocks; and, (2) a slightly higher inflation rate.

And, since about 1980, the deflationary effects of workforce productivity growth (see our blog entry of 1/2/06) have dominated any inflationary effects of government deficit spending.