Government Debt, Dividend Growth, and Stock Returns

Abstract

This paper documents that the increase in public debt can lead to higher dividend payout to shareholders, which suggests public debt can be a strong cash flow predictor which helps better predict future stock returns. Specifically, the higher public debt-to-GDP ratio can predict both higher dividend growth and higher stock returns, and the predicted changes are in the same magnitudes. The finding is consistent with Lettau and Ludvigson's (2005) argument that there exists a common component among stock returns and dividend growth. We argue that i) public debt can drive the co-movement among returns and dividend growth, and the existence of a common component can resolve the US asset pricing puzzle as emphasized by Cochrane (2007, 2011) that the dividend-price ratio can only predict discount rates but not cash flows; ii) the strong cash flow predictability of the public debt-to-GDP ratio can not be consumed by the popular consumption-to-wealth ratio (cay) and many other macroeconomic states variables; iii) future stocks returns can be better out-of-sample predicted after controlling for public debt. The empirical evidence documented in the US aggregate market can also be extended to the US cross-section and the international markets, especially for the advanced financial markets, which helps to explain the weak cash flow predictability recently documented by Rangvid et al. (2014) and Maio et al. (2015). To rationalize the finding, we propose a production-based asset pricing model incorporating cash-retention friction on the corporate sector. The model can produce testable predictions that the increase in public debt moves both dividend payment and the cost of capital in the same direction, resulting in the capture of the common component.