The stats don’t lie: Surpluses, deficits and the cold hard data

As the old joke goes, get 10 economists in a room and you will get 11 opinions. Today we pen the first ‘The Stats Don’t Lie’ feature – musings that put emotion and conjecture to the side and looks at the hard evidence. Today I want to look at the impact of government budgets on the stock market.

As politicians fight tooth and nail to deliver the first budget surplus since the GFC, we ask a simple question: is fiscal forbearance good for the stock market or bad?

Conventional wisdom suggests that surpluses are a good thing, and deficits are somehow bad where we are living beyond our means. The argument runs that unbridled deficit spending increases government debt leading to slower growth and the potential for stock market gyrations.

What does the evidence say?

Well, if we look at US data, which gives us a much longer history than Australia, we get a surprising result. Surpluses coincide with poor periods of stock market performance while deficits accompany strong periods. Periods with large deficits including the recovery from the Great Depression, World War II, the 1980s, and the last decade were marked by strong periods of stock market performance.

When the budget was in deficit the average stock market return over the next year was a robust 9.8% and was up 73% of the time. When the budget was in surplus, the average stock market return was a pitiful -1.9% and was up as often as it was down.

Of course, this is not to say that governments should spend like a sailor on shore leave. We only have to look at the misadventures of Greece, and Argentina to name a few to see where that path leads. Nevertheless, it is a useful reminder that not all deficits are bad, and not all surpluses are good, particularly if we are trying to anticipate stock markets over the near-term.

At Plato Investment Management, we put the talking heads on TV and emotion to the side and invest by the numbers.