Most governments are spending far more than they’re receiving right now, and spending is growing rapidly in some of the world’s largest economies. Debt piles are growing relative to the size of economies. But does this actually matter for investors?
Now, you’d think it would matter! Intuitively, such fiscal largesse feels like government ill-discipline. And we’d expect wayward politicians’ behaviour to be punished by censorious market players such as “bond vigilantes” or large hedge funds. But is this how markets work in practice?
A good way to tackle this type of question is to see what’s happened in the past when similar situations arose. To answer this properly, I engaged Aabid Seeyal Abdul Kharim, a Masters student at the University of Edinburgh, to run the numbers. While we enjoyed the summertime, he examined the relationship between fiscal deficits and asset prices using a long series of US data. His results were fascinating and ‘non-intuitive’, but largely tallied with results from earlier studies:
In summary, government deficits predict positive equity excess returns at short horizons. The effect is modest, but it’s statistically significant and the results still hold when taking account of the business cycle. Further work to identify the cause of the effect shows that deficits predict earnings growth strongly. By contrast, there is no evidence that the deficit or any of its components predicts bond excess returns over horizons up to two years.
See also: Licence to yield: Why bonds deserve a second look
In plain English, government spending deficits are good for company earnings and share prices; but don’t have much of an impact on bond yields, at least in the short and medium term.
This is very helpful for asset allocators: it provides a ‘baseline’ for thinking about today’s situation. We need to be careful, though, because in the long-run, everything changes. It’s quite possible that while deficits are benign for asset prices at first, they eventually evoke a reaction. Bond yields might rise beyond some threshold and share prices could get hurt.
Inside the investment committee, we’ve been thinking about the strength of company earnings for some time. Aabid’s research puts some of that strength into perspective. And like other investors, we almost always think about government bond yields.
David Scammell, who sits on our committee and has a wonderful background in central banking and fixed income, has been particularly helpful in guiding us through the past few years. He has consistently highlighted large and growing government bond issuance; plus who might buy these bonds and what sort of returns they require.
See also: Chris Jones: Confessions of an unregulated mind
When the yield curve was shallow or even inverted, he advised against taking on unnecessary duration (interest rate risk). When we’ve thought about index-linked gilts, he’s warned us that these usually come with duration too. And he’s framed the past few years as a normalisation of interest rates (probably a good thing) rather than something inexplicable. As a result, when we’ve invested in bonds, it’s been with short duration and this has been useful up to now.
The next investment committee meeting will be fascinating, because there are so many potentially important things to consider. Yes, we still have huge fiscal deficits to think about, but we’ve also got an AI/ data-centre spending boom; war and its impact on inflation; rising bond yields and their impact on mortgages; plus a rising yen and its impact on carry traders and speculators. What a time to be an investor.
James Clunie is a member of the Tyndall Partnerships Investment Committee
