Global debt: Are stock, bond returns affected?

February 1, 2011

Although rising levels of government debt create headwinds for economic growth, a country's deficit and debt levels do not seem to adversely affect capital market returns.

Key Points

Government efforts to stimulate these economies out of recession may partly explain the current level of borrowing, which is high compared to historical levels. But longer-term trends such as aging populations, expanding public pensions, and rising health care obligations are compounding the fiscal challenges of these countries as well.

However, rising deficits do tend to drive up interest rates. As borrowing increases, a government must offer higher interest rates on its debt to compete for capital. Additionally, as debt levels rise, market concerns about higher default and inflation risks put additional upward pressure on interest rates.

A country's economic growth does not always equate to healthy stock market returns. Several factors may contribute to this decoupling effect. For one, with globalization, a multinational company's stock price in its home market may not reflect economic conditions in other countries. Also, the benefits of economic growth do not accrue exclusively to public companies, but also to income earners, non-public businesses, and private investments.

Finally, consider that risk, not economic growth, determines a stock's expected return. Similar to value and growth stocks, markets with a low aggregate price (relative to aggregate earnings or book value) have high expected returns, and markets with a higher relative price have lower expected returns. Consequently, while holding a "growth market" may be a rational investment approach, investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected gross domestic product growth.

Many believe that large fiscal deficits and high debt cause a currency to depreciate as the government borrows more from foreign sources, and investors who are concerned about inflation and default risk flee the currency. Although recent developments in the U.S. would seem to support this scenario, there is less convincing long-term evidence that deficits affect currency rates. Exchange rates appear to move randomly, making it difficult, if not impossible, to reliably and consistently forecast currency returns.

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, the investment implications are not easily discerned. History does not offer strong evidence that current deficits predict future bond or equity returns in a country's financial markets, or anticipate short-term currency movements. Investors should assume that stock and bond prices tend to reflect all that is currently known and expected about government spending and debt, economic growth, risk, and other issues affecting performance.

Q: Does it make sense to take Social Security payments earlier than the full retirement age?

A: The age you elect to start receiving Social Security benefits affects the amount of monthly benefits you collect for the rest of your life. Receiving benefits before retirement age can reduce your monthly benefit by as much as 30%.

For example, if you were born in 1960 or later, your full retirement benefit age is 67. If you elect to receive benefits at age 62, you'll only receive 70% of the monthly benefit than if you had waited until age 67. If you wait until age 65, you will get 86.7% of the monthly benefit.

While you can work part-time and still receive Social Security benefits, you may receive a reduced monthly benefit until you reach your full retirement age if you earn more than the annual limit.

Look at all potential sources of retirement income, including pensions, retirement income, and part-time work as you calculate when to take benefits. The Social Security administration's Web site, http://www.ssa.gov/, provides calculators that can help you determine the timing that's right for you.

Joel M. Blau, CFP, is president and Ronald J. Paprocki, JD, CFP, CHBC, is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago. They can be reached at 800-883-8555 or blau@mediqus.com
or paprocki@mediqus.com
.