William Atwood, executive director of the $11.5bn Illinois State Board of Investment, shares his views on the implications of last month's US debt downgrade
On the evening of Friday, 5 August, Standard & Poor’s announced they were downgrading the debt of the United States Treasury from AAA to AA+. By any measure this was a historic decision—the first time US Treasury securities were ever downgraded, or that they had ever been rated below AAA. At the same time the condition of the US economy and the federal treasury was no different Friday evening than it was Friday morning. On Saturday life carried on, and although the week after the S&P announcement was marked by extreme market volatility, by the following week global equity markets had calmed and equity valuations surpassed their pre-downgrade levels.
US treasury debt remained as investors’ safe harbor, and following the S&P downgrade yields on US Treasuries actually declined. In fact, on Monday, 8 August, the Illinois State Board of Investment (ISBI) was actively selling Treasuries – not due to credit concerns, but because their price ran up, in particular relative to equities. While S&P’s actions demanded the attention of the professionals at ISBI, it has not caused us to make any changes to the portfolio, nor will it in the foreseeable future. My concern as executive director was not related to the near-term utility of US Treasury securities in an institutional portfolio, but rather what the condition of the US economy, and the fiscal health of the federal government, portends for investors.
The materiality of the S&P downgrade is not so much related to the ongoing desirability of US debt – similar to ISBI, it is unlikely that market participants will change their investment decisions related to US Treasury securities based on S&P’s analysis alone. Rather, the significance of S&P’s decision was in their willingness to say what the world was thinking: The deal reached earlier in August to raise the US debt ceiling and reduce the federal deficit was insufficient; the powers that be in Washington have not adequately executed their duty to manage and lead the US economy; and whatever the current worthiness of US credit, it is lower now than it was in the past.
Sovereign debt amounts to a promise on the part of a nation’s political leadership to creditors – the nation’s economy will be managed in such a way so as to insure the repayment of debt; and failing that, those leaders commit to extract funds sufficient to cover the debt from their constituents. So the two critical variables from the point of view of creditors are the technical capacity of leadership to manage the fiscal affairs of the government; and their political capacity to raise taxes, reduce services, or both – to reduce the standard of living of the citizenry – sufficient to pay the nation’s debts.
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