Fiscal Policy and Markets

The influence of fiscal policy on financial markets
Fiscal policy exerts a multi-channel influence on financial markets. Changes in taxes and spending affect economic growth, inflation, interest rates, and corporate earnings. Understanding these interrelations is necessary to assess the market consequences of fiscal decisions.

Impact on the bond market
Fiscal expansion (growth in spending or reduction of taxes) increases the budget deficit and the need for borrowing. Growth in the supply of government bonds, all other things equal, raises their yields (lowers prices). This supply effect is particularly significant when deficits are large. Fiscal stimulus also stimulates the economy, raises inflation expectations, and may lead to a tightening of monetary policy. All these factors are negative for bonds. Fiscal contraction has the opposite effects: reduction in bond supply, slowing growth, lowering inflation expectations — positive for bonds, but negative for the economy.

Impact on the equity market
Fiscal stimulus during a recession is usually positive for stocks: economic growth supports corporate earnings. However, the effect depends on the structure of the stimulus and the reaction of monetary policy. Lowering corporate taxes directly increases net profit and is usually positive for stocks. The 2017 U.S. tax reform, which lowered the corporate income tax rate from 35% to 21%, was a significant positive for the stock market. Growth in government spending creates opportunities for companies receiving government contracts. Defense contractors, construction firms, IT companies working with the government benefit from increases in relevant budget items.

Sectoral effects
Fiscal policy has pronounced sectoral effects. Infrastructure spending is favorable for construction, manufacturers of building materials, heavy machinery. Increases in healthcare spending support medical companies, insurers, pharmaceuticals. Defense spending is important for the military-industrial complex. Tax changes also exhibit sectoral differentiation. Industry tax benefits and subsidies affect the competitiveness of sectors. For example, subsidies for renewable energy are favorable for corresponding companies.

Political cycle
Fiscal policy is subject to the political cycle. Governments may increase spending or cut taxes before elections, creating a pre-election boom. After elections, consolidation measures may follow. Political risk affects perceptions of fiscal sustainability. Political instability, the risk of populist policies, uncertainty regarding the future course increase the risk premium of sovereign bonds.

Coordination with monetary policy
The interaction of fiscal and monetary policy influences the final macroeconomic outcome. Coordinated expansion (loose monetary and fiscal policy at the same time) creates maximum stimulus. Policy conflicts (loose fiscal, tight monetary) may lead to crowding out and a limited effect. In a zero-rate environment, fiscal policy becomes more important, since monetary policy is constrained. This creates arguments for more active use of fiscal stimulus.

Application for investors
Monitoring the budget process and political debates on fiscal policy is important for understanding future trends. Budget proposals, reports from parliamentary committees, political statements provide information about likely changes. Assessment of the fiscal impulse — the change in structural deficit — shows the direction and strength of fiscal policy. A positive impulse means stimulation, a negative means consolidation. Cross-country differences in fiscal policy create opportunities for relative bets. A country with fiscal expansion, all else equal, will have higher growth, but also higher rates, than a country with consolidation.