Indiana Trust Wealth Management
Investment Advisory Services
by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services
- The US equity market, represented by the S&P 500 index, fell 2.3% for the week ending August 4.
- Fitch Ratings downgraded US debt this week. It was shrugged off by the bond market.
On Tuesday evening this week, Fitch Ratings, one of the three major credit ratings agencies, downgraded the US debt from AAA (its highest rating) to AA+, one notch lower.
The US stock market fell the next day, and some attempted to link the decision to downgrade the world’s safest financial asset to the market decline. The stock swoon on Wednesday could be the result of many catalysts, but it is unlikely due to the Fitch downgrade. While it makes nice headlines for Fitch, the downgrade means next to nothing for capital markets.
Fitch cited recent debt ceiling debates as a reason for the decision. The debt ceiling has been a political football for decades. Does it make sense that the world’s largest and most liquid capital market – the market for US Treasury bonds – has not taken this risk into account?
Nor does the downgrade have much to say about the long-term “sustainability” of the path of the US debt. If “sustainability” is narrowly defined in a financial sense – will the dollars be there? - there is no financial constraint on Uncle Sam. There is no reason for the US to default on its bonds or on any future financial obligation it faces in US dollars.
Former Federal Reserve Chairman Alan Greenspan made this clear in Congressional testimony in 2005 when asked what the US government should do to make future Social Security benefits “more secure”. He responded that future benefits are not insecure in the sense that the money will not be there. “There is nothing to prevent the US government from creating as much money as it wants and paying it to somebody,” Mr. Greenspan stated. (Presumably, that includes bondholders.)
Mr. Greenspan then cut to the heart of the issue: “The question is, how do you set up a system that ensures that the real assets are created which those Social Security benefits are employed to purchase. It is a question of the structure of the financial system which ensures that the real resources are created for retirement as distinct from the cash. The cash itself is nice to have, but it’s got to be in the context of the real resources created at the time those retirement benefits are created.”
In other words, US debt “sustainability” should be measured relative to the US economy’s future productive capacity. It entails projecting future labor productivity, technology shifts, demographic advantages, strength of private and public institutions, the country’s vast natural resources, future public policy choices, and any other “unknown unknown” criteria. Not easy to measure.
Even should one be able to come up with such a projection, what is the “sustainable” level of US debt in that context? Again, very difficult to figure, which is why most investors decided long ago that “credit ratings” do not apply to the US federal government.
Fitch and other ratings agencies serve an important function: the credit analysis of the debt of corporations and state and local municipalities. The US federal government is a different matter. Or, as Edward Al-Hussainy, a senior analyst at Columbia Threadneedle noted, “the US credit rating is singular — there is no general methodology for rating the world’s pre-eminent safe haven asset.”
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