So how does public debt affect economic growth and market returns? The evidence might surprise you. Let’s explore these issues by addressing a few popular questions about sovereign debt:

Do rising deficits drive up interest rates?

Yes. As borrowing increases, a government must offer higher interest rates on its debt to compete for capital. The public sector consumes savings and investment that may have otherwise fueled private sector growth-a displacement of resources known as the “crowding out effect” in economic theory. However, today’s interest rates and bond prices already reflect information about current government spending, and markets quickly incorporate new information.

Do higher deficits hamper economic growth?

It depends on a country’s debt level. Using World Bank data from 1991 to 2008, we found high-debt countries that run deficits are more likely to experience lower economic growth over the next three years. But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation in future GDP growth.

Does low economic growth result in diminished equity returns?

No. This relationship can be tested by comparing a country’s GDP growth to its equity market performance in subsequent years. We conducted this analysis using all the developed countries in the MSCI universe, divided each year into high-growth and low-growth “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.

The graph below illustrates this relationship in terms of a dollar invested in high- versus low-GDP growth portfolios from 1971 to 2008. The low-GDP growth portfolio’s higher annual return would have generated slightly more wealth for the period. The chart details the average annual return and real GDP growth for both groups.

Applying the same methodology to the MSCI emerging market countries shows an even greater return difference, although the data period is much shorter (2001 to 2008). The return of the high-growth country portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the low-growth portfolio (-4.94% GDP growth).

Is it because of the simple principle I wrote about on Morngingstar? It is highly likely. Overall, it is harder for lower growth countries to get capitals, therefore in equilibrium they have to offer up more expected returns to attract investors.

Conclusions

Some economists claim that developed market countries are moving into an era of high government deficits and lower market returns. While higher deficits and debt may impact a nation’s interest rates and economic growth to some extent, history does not offer strong evidence that current deficits predict future bond or equity returns.

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