Stock Outlook: The Austerity Dilemma

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 |  Includes: GLD, SLV, SPY
by: Eric Parnell, CFA

Fiscal austerity is bad for the stock market (NYSEARCA:SPY) since it serves as a drag on economic growth.

I have expressed this view in several recent articles, and this statement has inspired some strong comments from a number of readers. At issue is the notion that the above view on fiscal austerity suggests support for Keynesian style policy response by the public sector in working to generate economic growth. This is absolutely not the case, however.

Fiscal austerity does not follow the Keynesian model in any way. Instead, it is in many ways diametrically opposed to the Keynesian approach. This is due to several key differences that can be understandably missed when thinking about fiscal austerity versus the Keynesian approach.

During periods of economic weakness, including high unemployment, the Keynesian model advocates increased government spending in order to help offset the loss in output resulting from reduced consumer and business spending. But in order to increase government spending, Keynes generally advocated deficit spending instead of raising taxes so as to not discourage consumer and business spending.

For context, it is worthwhile to examine this in the context of the expenditure approach to GDP, which is shown below:

GDP = C + I + G + (X - M)

Where

C = private consumption (think consumer spending)

I = gross private domestic investment (think business spending)

G = government spending

X - M = net exports (exports minus imports)

Under the Keynesian model, the strategy during persistently high unemployment is to increase the "G" component of GDP through deficit spending while not taking action to discourage the "C" and "I" components. In fact, Keynes would favor lowering taxes under such a scenario, not raising taxes, in an effort to promote increased consumer business spending. The resulting idea was that a direct increase in the "G" component of GDP accompanied by providing support for increases in the "C" and "I" components of GDP, all of which would promote overall economic growth. In short, INCREASED government spending and potentially LOWER taxes to promote GDP growth.

Contrast this with the fiscal austerity now being applied in Europe and under consideration in many countries across the globe.

Under fiscal austerity, a government is facing a situation where it may no longer be able to manage its debt liabilities. Using the United States as an example, this would be a situation where the U.S. government could no longer make its interest payments or return principal to investors in U.S. Treasuries. And this is the dilemma now facing countries like Greece, Portugal, Ireland, Italy, Spain and perhaps others across the Euro region.

In order to address this problem, governments are entering into a policy approach of cutting back on government spending in order to set aside revenues to service debt. At the same time, taxes are being increased on the private sector in order to generate additional revenues for government debt payments.

Let's return to the expenditure approach of GDP to assess the impact of such fiscal austerity.

GDP = C + I + G + (X - M)

Under this approach, the "G" component of GDP is being lowered to divert money for debt payments. At the same time, the "C" and "I" components of GDP are being pulled lower as both consumers and businesses are forced to divert money that they would otherwise spend on goods and services to tax payments to the government. And these tax payments are being allocated for debt payments. The result is a direct reduction in the "G" component of GDP while at the same time draining the resources behind the "C" and "I" components of GDP. In short, DECREASED government spending and HIGHER taxes, both of which hurt GDP growth.

This analysis does not imply that I am for or against the Keynesian approach or fiscal austerity. In fact, each has application in very different circumstances, so it's not necessarily a choice between one or another. And to the contrary, my belief is that governments should act prudently during periods of prosperity to help avoid the need to engage in either scenario once recessions unfold. But such forethought and preparedness did not occur in advance to help offset the problems that many governments are now facing today, and fiscal austerity is now among the only remaining choices in many cases.

The prospect of lower GDP growth due to fiscal austerity is negative for the stock market outlook. This is due to the fact that the primary driver of stock market returns is earnings growth. And the primary driver of earnings growth is GDP growth. If GDP growth is shrinking, this places a drag on earnings growth. And if earnings growth is declining, this will eventually seep its way into the stock market. In addition, this negative impact can be compounded during periods when corporate profit margins are at historical peaks (as they are today) and stock market valuations are elevated (as I would contend they are today), as periods of slower GDP growth typically cause profit margins to compress and investors to require discounted stock valuations. All of these forces are unequivocally negative for stocks.

Make no mistake, fiscal austerity is bad for stocks because it's bad for economic growth. This is neither a statement in support of Keynesianism nor against fiscal austerity. Instead, it's a statement in recognition of the fact that if consumers, businesses and the government are all diverting scarce resources away from producing output toward servicing debt, this stunts both economic growth and corporate profitability. And while ongoing monetary largesse may help keep a lift under stocks for the time being under such a scenario, it's only a matter of time before the ink in the money printing presses eventually run dry. Instead, these are conditions that may be most supportive of safe haven hard assets such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) before it's all said and done. Such is the dilemma facing European policy makers as they summit once again this week. Bonne chance!

Disclosure: I am long GLD, SLV.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.