Economic webcast

Our latest monthly webcast is now available: Is the COVID-19 recovery sustainable?

Overview

The arrival of a new month presents an excuse to reflect back on the key themes from each of the prior several months. March was defined by the widespread arrival of COVID-19 and the resultant descent into quarantine. April represented the nadir from an economic standpoint and the peak from an infection count perspective across much of the developed world. The month of May, in turn, marked the beginning of the economic recovery.

What will June bring? Our best bet is a further continuation of the recovery, though there is a significant and rising risk that some jurisdictions will have to beat a retreat back to stricter social distancing.

With regard to how our own thinking has evolved over the past week, it has been on the aggregate a fairly steady affair.

Negatives include:

• The number of daily global infections continues to mount after a long period of stability, with emerging market nations leading the charge.
• Some U.S. states that had previously eased their social distancing policies are now suffering a significant jump in new cases.
• It seems likely that the demand for apartments will be damaged above and beyond the generalized short-term weakness expected in the broader housing market.

Positives include:

• The global fatality rate is still declining – arguably a more accurate proxy for the presence of COVID-19 than the formal infection rate.
• Real-time data indicates that the economic rebound continues.
• Quite a number of countries and U.S. states have eased their lockdown orders without suffering an increase in new cases.
• Japan presents the tantalizing example of a country that has managed to limit COVID-19 without strict social distancing or aggressive testing. Perhaps it can be a model for others.

Virus developments

The global infection figures have continued to deteriorate. There’s a current trend of between 100,000 to 120,000 new cases now reported per day – higher than the roughly 80,000 daily cases that had prevailed for more than a month. There have now been more than 6 million total infections according to the official count.

Fortunately, the global death rate has evinced the opposite trend, declining steadily since mid-April (see chart). We tend to trust this data more than the infection estimates. Still, it would be greatly preferable if both were declining.

Global new cases rising while deaths declining

Note: As of 06/01/2020. 7-day moving average of cases & deaths indexed to 100. Source: ECDC, Macrobond, RBC GAM

There continues to be a sharp divide between developed and emerging economies. The former are enjoying a declining number of new infections, but the latter are suffering a rising trend. While the virus is far from eradicated in developed nations, emerging economies are arguably the new epicenter. The caseload continues to accelerate in Brazil, India, Mexico and Russia.

In the developed world, Canada has improved nicely (see next chart), with Ontario roughly flat but Quebec, British Columbia and Alberta all looking better. The U.K. has also recorded a substantial further improvement.

New cases vs. deaths trend in Canada

Note: As of 05/29/2020. 7-day moving average of cases & deaths indexed to 100 = peak. Source: ECDC, Macrobond, RBC GAM

Considerable U.S. variation

In the U.S., the national figures are fairly happy. There’s a moderate reduction in daily infections and a sharp decline in daily deaths relative to their April peaks (see next chart).

New cases vs. deaths trend in the U.S.

Note: As of 05/29/2020. 7-day moving average of cases & deaths indexed to 100 = peak. Source: ECDC, Macrobond, RBC GAM

However, at the regional level, the U.S. is a much more mixed proposition. There are certainly states such as New York and Illinois that are enjoying a sharply declining infection rate, and others like Michigan and New Jersey that have managed a substantial improvement before flattening out.

However, a significant fraction of U.S. states are struggling. California’s caseload has risen substantially since the state reopened on May 12. North Carolina and Alabama’s daily new cases have more than doubled since reopening. South Carolina and Wisconsin are also suffering a substantial increase.

Curiously, Florida and Georgia – some of the more enthusiastic states to restart operations – are still managing a roughly sideways trajectory. As such, the story remains quite blurry.

Testing statistics

It is useful to occasionally revisit COVID-19 testing figures. The rate of testing has increased with time, an example of rising government competence in grappling with the virus. Simultaneously, the positive rate has generally declined. This makes sense: with a limited number of tests, one might start by only testing those with a fever, cough and exposure to the disease. As the testing capacity expands, the tests include people who are incrementally less likely to have been infected.

Thus, for a particular testing rate per capita, a higher number of positives hint that a country is undercounting its true cases to a greater extent than its peers (see next chart). As such, it would appear that among developed countries, France, Sweden, the U.S. and Spain may be undercounting their true number of cases more than the rest. Conversely, the extremely low positive rate of tests in China, South Korea, Japan, Russia and Germany suggest little is being missed.

COVID-19 diagnostic testing varies significantly by country

Note: Most recent available data as of 06/01/2020. Reporting frequency varies by country. Source: Our World in Data, ECDC, RBC GAM

Not long ago, we were quite concerned that Russia’s outbreak was spreading like wildfire. The country’s positive rate on tests was rising even as the testing itself accelerated. Mercifully, that is no longer the case: Russia’s positive rate is now notably low.

The South Korean data recently demonstrated another interesting pattern as the country grappled with a sudden outbreak of COVID-19. Its testing rate skyrocketed for a brief period of time, indicating that the country now enjoys the luxury of significant spare testing capacity that it can direct like a heat-seeking missile toward hotspots. This is something that all countries should aspire to.

The recovered

It is easy to forget that the cumulative infection figures include people who have since recovered. It is not unreasonable to wonder what the actual number of actively infected people is. Unfortunately, this information is hard to come by at the global level. Happily, the U.S. publishes its own figure. It is welcome news that the total number of infected in the U.S. may be starting to peak (see next chart). This is to say, the number of new sick people each day is on the cusp of being outweighed by the number of people declared newly disease free.

Although the bulk of the transmission of COVID-19 likely comes from people who have only recently been infected and are not yet aware of their condition, the transmission rate surely declines at least slightly if there are fewer overall people who are actively sick. At a minimum, this development means that fewer people are suffering unpleasant symptoms and are at risk of dying.

Active case curve starting to plateau in the U.S.

Note: As of 05/31/2020. Source: The COVID Tracking Project, Macrobond, RBC GAM

In Canada, it appears that the number of infected people is already in slight decline – a momentous occasion that has gone under-remarked.

Economic developments

Our suite of real-time indicators have made mostly positive claims over the past week. Mobility data points to a further normalization of activity, and a measure of news sentiment has finally begun to rise off of very low levels. The number of U.S. air travelers per day has nearly tripled, though remains quite depressed by prior standards. On the other hand, the Redbook retail sales data has only rebounded modestly, failing to corroborate the claim of credit card indicators that spending has bounced by more than half.

The latest Beige Book has been released, providing an anecdotal and qualitative look at the U.S. economy through the eyes of businesses. The report largely confirms our prior prejudices:

• Sales suffered a sharp decline in April before staging a tentative rebound in early May.
• Employment continued to decline throughout the surveyed period, but COVID-19 was becoming slightly less pressing with “only” 82 mentions versus 126 in the prior report.
• Interestingly, inflation was described as steady to lower. Items such as apparel and travel became less expensive, but certain foodstuffs became more costly.

Households

A variety of measures provided a window into the position of American households.

U.S. initial jobless claims declined once again, to 2.1 million in the latest week, from 2.4 million in the week before. This improvement is welcome, but it is nevertheless disturbing that several million additional people appear to be losing their job each week, even after more than two months.

Fortunately, the continuing claims points to a more optimistic conclusion, with a decline from 24.9 million to 21.0 million. In other words, a significant number of people lost their jobs as per initial claims, but even more found a new job. Fully 35 of 50 states recorded an improvement, though 80% of the decline in continuing claims came from just two states (Florida and California) known for their volatile figures. There could be a bit of backsliding in the next week’s data. In the end, though, it makes complete sense that the labour market has pivoted toward job creation – it would be impossible for business revenue and spending activity to be reviving in any significant way without a simultaneous increase in workers providing these goods and services.

U.S. personal income and spending data for April has now been released. The personal income data diverged from expectations to a nearly unprecedented extent, rising by a huge 10.5% versus a consensus expectation for a 6% drop. We can’t say that we anticipated such a powerful increase, but our analysis had suggested that personal income had held up surprisingly well thanks to the help of government stimulus.

This income boost didn’t help spending much, however. Increased risk aversion persuaded households to spend a sharp 13.6% less in April, on top of a 6.9% drop in the prior month. That makes for a cumulative drop in consumer spending of 21%, in line with our prior assumptions. The income figures do present the possibility that the spending could come racing back more quickly than imagined, however.

Business investment

A variety of metrics also shed light on the situation for business investment. After falling 17% in March, U.S. durable goods orders fell by a further 17% in April. Together, this makes for a 31% decline. This drop was heavily skewed toward transportation equipment.

We have constructed a model that attempts to forecast business investment using a variety of leading indicators (see next chart). The model recently fell further, pointing to as much as a 45% drop in business investment on a year-over-year basis. It had only pointed to a 25% drop as of a few weeks ago.

U.S. capex indicators nose-dived

Note: Capital expenditures (May 2020) are 3-month moving average of an aggregate of normalized indicators of future and current capex from surveys on manufacturing and non-manufacturing firms conducted by the NFIB, the Federal Reserve Bank of Chicago, Dallas, Kansas City, New York, Philadelphia, and Richmond. Real equipment investment as of Q1 2020. Source: Haver Analytics, RBC GAM

On the other hand, the classic ISM (Institute of Supply Management) Manufacturing index has just been released for May. It points to a slight rebound from 41.5 to 43.1. This remains below the 50 level that traditionally separates growth from decline, but is no longer at depression type levels.

Overall, it seems as though consumer spending is arriving roughly in line with our expectations. There’s some upside risk given the household income data, but the capital expenditure data is proving somewhat weaker than expected.

Canadian data

Canada’s March GDP data has now been formally published, revealing a 7.2% decline relative to February. This is moderately better than Statistics Canada’s initial flash estimate of -10%. The statistical agency further published a special flash estimate for April GDP, estimating a further 11% decline. Cumulatively, this is a 17% decline in Canadian economic output from February to April. That figure is enormous by any prior standard, but slightly better than our own assumption.

The Canadian Federation of Independent Business has done yeoman’s work in producing a high-frequency measure of small business confidence in Canada. The measure is calibrated so that 50 represents flat activity. It fell to as little as 30.8 at the end of March, but has since rebounded to 52.5. The represents more than a two-thirds recovery to the prior level of 60.

Looking ahead

A few major data points are set to be released later this week.

U.S. payrolls are forecast to report the loss of a further 8 million jobs. That’s in addition to the 21 million workers shed over the prior month. The unemployment rate is expected to rise from 15% to 20%. Note that the jobs report is tabulated such that it only really captures changes from mid-April to mid-May. We suspect the June version will reveal a return to net job creation, as per the earlier discussion about declining continuing jobless claims.

Canadian employment is expected to suffer a proportionately tamer loss of 500K jobs, on top of the (proportionately worse) 3 million already lost. Canada’s employment data is slightly less lagged than the U.S., helping to explain this difference.

The Bank of Canada will deliver its next rate decision later this week, with new Governor Tiff Macklem at the helm. Given the tentative economic revival and reasonably contented financial markets, we do not expect a significant pivot. A negative policy rate seems quite unlikely, a turn toward yield-curve control policies seems premature, and quantitative easing efforts are already considerable.

Comparing forecasts

Last week’s note laid out nine different scenarios for how economic growth could unfold over the remainder of 2020 and into 2021. The following chart provides a visual depiction of the most optimistic, middle and most pessimistic of the nine scenarios – the difference is substantial, reiterating the point that no one knows with precision how the coming year will unfold.

Potential trajectories of U.S. economic growth

Note: As of 05/21/2020. Best-, middle- and worst-case scenarios are RBC GAM projections based on different assumptions on duration and depth of COVID-19 impact to economic activities. Source: Macrobond, RBC GAM

Oil stages a partial revival

The oil market has experienced an unprecedented shock over the past several months. The price of West Texas oil started the year at $60 per barrel, plummeting to a mind-bending negative $38 as refiners completely ran out of room to store the surplus product. Mercifully, this trip through the looking glass proved short-lived, with oil prices back to positive levels fairly quickly. But oil then spent a chunk of time in the paltry $10 to $20 range, only gradually reviving until the point that it now trades at $34 per barrel. This is still quite low, but is a considerable rebound all the same.

What permitted oil to recover so dramatically, if incompletely? It was a mix of supply and demand developments.

Demand remains quite weak, but has seemingly revived significantly as people resume driving. Apple mobility data in particular indicates that people are now driving nearly as much as before COVID-19. We find this hard to believe given the large number of people who are now unemployed or working virtually, but we can believe that some amount has returned. Fuel consumption by airlines remains quite low, but is also rising substantially.

On the supply side:

• The production dispute between Saudi Arabia and Russia has ended.
• OPEC agreed some time ago to cut 10 million barrels of oil. Saudi Arabia has since pledged to pare its production even further.
• Private-sector producers in other countries have now slashed production, including in Canada and the U.S.
• American drilling is now at its lowest level since the early 1990s, indicating little scope for new supply to be brought online in the immediate future.

Reconciling the convergence of supply and demand from very different starting points, crude oil inventories are no longer aggressively rising. U.S. oil inventories now appear to be flattening out, and Chinese inventories have reportedly started to decline.

The oil market is clearly in a much better position than it was two months ago. However, crude prices are still quite low, to the extent that many producers struggle to break even. Furthermore, additional investment into the sector seems unlikely at these levels. As such, it is still an extremely difficult time for the sector as a whole, and this is unlikely to resolve particularly quickly.

One interesting aside is that, as oil prices have rebounded, the oil shock is no longer actively weighing on inflation. To be sure, its effect will continue to be felt in the year-over-year CPI (Consumer Price Index) print for some time. But on a month to month basis, oil prices are no longer falling. This is already visible in real-time inflation data that appears to now be bottoming, albeit at a low rate of inflation.

The secret of Japan’s success

As we search the world for examples of countries that have done an especially good job of controlling COVID-19, China, South Korea and Japan immediately stand out. China was able to quiet the virus largely via extreme quarantining. South Korea did the same via extensive testing and tracing. Curiously, Japan has done neither of these two things. In fact, it has among the lightest social distancing measures in the world and among the lowest testing rates.

You could be forgiven for thinking that Japan should be a country at unusual risk of COVID-19, not just for the two aforementioned reasons, but because it is proximate to China, densely populated, has an old population, and was in the process of opening itself to the world for the now-delayed Tokyo Olympics.

And yet Japan has managed to snuff out two rounds of infection, once in mid-March and again in mid-April, now reporting a bare handful of cases per day (see chart). Lest there is concern that the country’s low testing rate is missing a massive number of cases, it should be noted that Japan’s positive test rate is extremely low and the country’s fatality numbers have also declined to quite low levels.

Spread of COVID-19 in Japan

Note: As of 06/01/2020. Source: ECDC, Macrobond, RBC GAM

What, then, explains the country’s spectacular success? Some have speculated that perhaps the actual amount of quarantining is as severe as elsewhere, but done voluntarily by the population rather than via government edict. But actual activity data argues otherwise, and recent retail sales figures show that the Japanese economic decline is around one-third less severe than the U.S. drop.

Plenty of arguments have been put forward, some more plausible than others:

• The country’s preference for bowing over shaking hands has been cited, though few people have been shaking hands in other countries over the past several months.
• Some cite the high levels of obedience in the Japanese population, but this is highly speculative and a bit clichéd.
• Japan has a lower level of obesity than in countries like the U.S. – a COVID-19 risk factor – but the country has kept the infection rate low as well, not merely the fatality rate.
• Japan has more hospital beds per capita than almost any other country, but the availability of hospital space has not been a binding constraint in most places despite initial concerns.
• One theory is that spoken Japanese creates fewer airborne droplets than other languages, though this seems highly speculative!
• We have some sympathy for the view that Japan better absorbed the lessons of the Diamond Princess cruise ship that was moored off its shore than did most others. The experience demonstrated that the virus was extremely contagious, and provided an early crash course in treating the infected.
• Japan stopped allowing large crowds earlier than many others, even as it continued to permit more ordinary levels of activity.
• We are inclined to put the greatest weight on the fact that the Japanese – and indeed, a fair swath of Asia – have been faithful mask wearers. Whether this prevents the wearer from being infected or not, it does appear to limit the ability of the wearer to transmit the virus to others. Given the high number of asymptomatic and mild cases, this would seem extremely valuable. In contrast, North American policymakers spent much of the pandemic discouraging people from wearing masks as they scrambled to ensure a sufficient supply for health care providers.

Japan’s example should provide hope for others. If other societies can be persuaded to don masks to a greater extent, a significant further revival in economic activity may prove sustainable.

Recovery risk

An economic recovery is now clearly underway. Some of this was enabled by governments that eased social distancing restrictions, with another chunk due to adjustments made in society more generally:

• a pivot toward online shopping
• companies introducing safety measures
• more testing and so on.

It is entirely conceivable that most countries are able to continue along the recovery path, incrementally returning their economies toward normal over the remainder of 2020 and through 2021. Japan provides a shining example, and every government has learned plenty of lessons along the way.

However, there remains the clear and arguably even rising risk that some jurisdictions will have to re-introduce restrictions. The virus count is already revving back up in such U.S. states as California, North Carolina and Alabama. Recent protests across the U.S. have put large numbers of people in close contact with one another, providing another potential spark.

When we seek to identify which jurisdictions at the national level are most vulnerable to a recurrence of COVID-19, one way to identify this is by focusing on which countries with a high transmission rate are significantly easing their lockdowns (see next chart).

Countries easing lockdowns with higher transmission rate at increased risk of a 2^nd wave

Note: As of 05/24/2020. Y-axis: deviation from peak lockdown, normalised to U.S.  Transmission rate calculated as 7-day % change of underlying 5-day moving average of new daily cases. Source: Google, University of Oxford, Apple, ECDC, UN, Macrobond, RBC GAM

Countries with a transmission rate of greater than one and that have been significantly easing social restrictions, such as India, Mexico and Brazil, are most obviously at risk. The U.S., Sweden and Canada also look to be somewhat vulnerable. In contrast, the significant easing taking place in Italy, France, Germany and Switzerland appears to be more defensible to the extent their transmission rates are notably below one.

Recovery speed

The initial recovery has come together faster than we had initially imagined, but we remain of the view that there are limitations on how quickly this can proceed. The primary reasons include:

• Governments are only easing restrictions incrementally.
• Economic demand is likely to remain depressed for some time
• Some supply-side issues should also manifest.

But there are also several reasons to think that the economic rebound could run into headwinds even without a second wave of viruses:

1. Even as economic activity revives, many businesses and households are enduring yet more months with a lower-than-normal income. These issues mount over time, eventually creating more serious solvency problems.

2. There are now second-round effects becoming visible in the economy. Initially, layoffs were constrained to businesses that were forced to close due to government restrictions. Now, additional layoffs are happening in businesses that are still permitted to operate but are finding that a broader economic malaise is setting in.

3. While the speed, size and targeted nature of the fiscal stimulus delivered so far has been truly impressive, much is scheduled to expire in the coming months. Realistically, governments will likely extend most such measures for longer, but that is not a certainty. A fiscal cliff could result.

At the moment, our base-case forecast is for a reasonably steady and enduring recovery over the remainder of 2020 and into 2021, resulting in a “mere” 7.1% decline in 2020 GDP. However, the next most likely scenario is a much more sluggish recovery, interrupted by repeated bouts of COVID-19. This would result in a worse 10.6% GDP decline in 2020.

Apartment peril

We wrote recently about our expectation that housing markets should be at least moderately weaker over the near term due to a mix of high unemployment, low risk appetite and diminished immigration.

Further to that, it seems likely that demand for apartment and condo rentals should be even softer, at least so long as COVID-19 is actively circulating:

• The allure of centralized vertical living has declined given the unattractiveness of elevators, the diminished need to be near shuttered offices, and the fact that social activities are now largely banned.
• Students constitute a significant fraction of apartment dwellers. International students have vanished nearly altogether, and many universities are now planning for a virtual fall semester, eliminating the need for students to secure lodging near campus.
• Many young people are moving back in with their parents as they no longer need to be near the office if they can work remotely, and they likely prefer the additional space offered by a family home.
• Having roommates is no longer an attractive proposition at a time of social distancing, incenting people to move home with family members.
• People who have lost their jobs will, by necessity, seek cheaper living options, with the family home likely cheapest of all.
• Apartments often constitute the initial launching pad for immigrants. To the extent immigration has slowed, demand from this group should fall.

While this still leaves plenty of demographics happily ensconced in apartment buildings, the detrimental effect to demand and rents is likely to be significant. To be clear, these are all short-term phenomena. Over the long run, schools will reopen, unemployment will fall and young people generally prefer some amount of independence rather than living indefinitely at home.

Corporate debt risks

Two factors have combined to make the corporate debt environment more challenging. First, weak economic conditions are damaging company revenues. Second, wider credit spreads have increased the cost of borrowing. Both compromise the ability to continue servicing debt.

These are unwelcome developments to the extent that corporate debt was already high as a share of GDP, and rising as a share of income (see next chart). Leverage has long been a tool to enhance corporate performance and was especially appealing over the past decade given ultra-low interest rates and slow economic growth, but it is not without risk.

U.S. corporate leverage on the rise

Note: As of Q4 2019. Shaded area represents recession. Source: BEA, Federal Reserve Board, Haver Analytics, RBC GAM

Fortunately, governments are trying to help on several fronts:

• A variety of loans and some grants have been distributed to businesses, helping to plug the holes in their income statement.
• Similarly, central banks have ventured into the corporate bond market, ensuring continued liquidity and a modicum of calm.
• Consequently, many companies have been able to roll their debt, reducing their liquidity risk while this pandemic plays out.
• It is also fortuitous that commercial banks have remained fairly healthy, increasing their overall lending and allowing companies to more fully tap their credit lines.

Despite all of this help, there is clear evidence of distress in some corners. Tens of billions of dollars of investment-grade debt has slipped into high-yield status, and the amount of debt classified as distressed has jump by 161% in just two months, to over half a trillion dollars. S&P reports that 88 companies have already defaulted on their debt – already nearly double the total from last year. Moody’s has predicted a high-yield default rate that could exceed 20% under adverse assumptions. The loss rate on defaulted debt has also been unusually high, above 80%.

A significant number of major bankruptcies have now occurred, including J. Crew, Neiman Marcus, J.C. Penney and Hertz. Some of these were perhaps inevitable given structural challenges, but not right away or all at once. The two most vulnerable industries are oil & gas and retail & restaurants.

To be clear, it is hardly the case that all businesses are in trouble. A simple thought exercise articulates this. Even if corporate revenues were to fall by 50% in 2020 – probably an exaggeration – the average company with a profit margin of 10% and a cost base that is 40% fixed versus 60% variable would expect to suffer a 35% decline in earnings – a big blow, but they are still technically earning money and likely able to continue servicing their debt given current interest coverage ratios.

The problem is that some businesses will suffer a sharper drop in revenues than the average, have a larger fraction of their costs that are fixed than the average, and/or are more leveraged than the average. It is this subset of businesses from whence trouble emerges.

Other pockets of the credit space are also clearly vulnerable, including:

• certain leveraged loans
• collateralized loan obligations
• leveraged private-equity plays.

The path for public debt

As governments shell out massive amounts of money to support households and businesses through this pandemic, public debt loads inevitably rise. The IMF anticipates a substantial 13 percentage point jump in the global government debt-to-GDP ratio in 2020, with further increases in subsequent years. The U.S. and Canada are forecast to experience debt-to-GDP increases of greater than 20% (see next chart).

Government debt pre-financial crisis, pre- and post-COVID-19

Note: IMF projections for year 2021. 2021 projections for world, advanced and emerging market economies estimated based on IMF projections for individual countries. Source: IMF, Macrobond, RBC GAM

We suspect the actual increase in debt ratios will be even larger than the IMF (International Monetary Fund) forecasts, to the extent that stimulus is likely to be extended for longer. All of this comes on top of the significant leap in government debt that occurred during the global financial crisis.

We are dubious that any serious effort will be made to pay down the additional debt accrued. At best, debt-to-GDP ratios might be allowed to inch lower over a multi-year period thanks to the magic of small deficits paired with moderate economic growth, but this is unlikely to fully return the debt profile to where it was in early 2020.

We do not believe that government spending will remain permanently larger due to COVID-19. Most of the fiscal measures have explicit end dates, and most are also linked to a specific need: when unemployment falls, so too will a big part of the government spending. And even if there were a desire to maintain some of the programs, governments would need to raise taxes aggressively to finance them. There is little talk or appetite for higher taxes at this juncture, particularly at a time when the economy is weak.

Fortunately, we expect that interest rates will remain extraordinarily low in the future, keeping most of the public debt affordable. Alas, this doesn’t make the debt entirely costless. The additional debt servicing costs – costing perhaps 0.3% of GDP – must be paid in perpetuity, and represent the redirecting of economic output away from more productive purposes and toward the servicing of debt. In turn, the sustainable rate of economic growth may prove slightly slower than before, with the rate of return on a variety of investments presumably a bit lower, too.

One can certainly think of a handful of Eurozone countries with already precarious debt loads, but recent steps by the European Commission toward a form of debt mutualization may reduce the likelihood of additional sovereign debt crises in places like Italy and Greece.

That said, some smaller countries are already defaulting on their debt. Argentina defaulted for a ninth time in late May. Of course, investors have long understood the risks associated with Argentina and other precariously positioned emerging market economies like Venezuela.

The true question is whether any trillion dollar-plus defaults might occur, in turn causing a cascading effect that imperils other investors, including major financial institutions. We view this as unlikely, not just because most major governments are likely to be able to afford their additional debt, but because major financial institutions are in a much better position to absorb any losses were they to occur.

As to whether there will be a temptation to try and inflate away the debt, we are on record with the view that this strategy invariably fails if pursued on a grand scale. If, instead, countries opt to allow a trickle of additional inflation to emerge, they could conceivably succeed in modestly reducing their effective debt burden (though, in theory, financial markets should be wise to this and price in an additional inflation premium, eliminating any enduring advantage). For this and other reasons, we have flagged the possibility of a bit more inflation than usual over the long run, but hardly view it as a certain destiny.

-With contributions from Vivien Lee and Graeme Saunders