The U.S. Federal Deficit and Market Equity Returns

Abstract

ABSTRACT Since the U.S. dollar has been operating as a fiat currency, there has been a strong link between U.S. government deficits as a percentage of GDP and forward‐looking equity returns. As federal deficits get larger, the expected return to the market over the subsequent 10 years increases. This effect is material. For each 1% increase in the deficit‐to‐GDP ratio, annualized returns increase by at least 1.29%, all else equal. However, this forecasting ability of the deficit‐to‐GDP ratio does not make it a market timing mechanism. Rather, it is a conditioning variable that helps determine the appropriate expected return for the market for financial planning and asset allocation.