Economies benefited from a variety of tailwinds throughout 2022, and even into early 2023 despite the tightening. Balance sheets at the family level are actually in better shape than they've been since Ronald Reagan was president. They can take some pressure. The very, very strong labour markets have been slow to cool. And until recently, there's been a slight easing of financial conditions off the rally in the in the stock market.

Then we move offshore outside of North America. Mild winter in Europe was obviously not expected. So that's turned out to be a much better experience. And in China, we now have the reopening. It's pushed the economy forward probably more than most of us expected. But there are some pretty significant headwinds which are hitting full force now.

In particular, we’re now one year since the beginning of the tightening of interest rates. Remember that interest rates are very effective, but they work with a long lag of anywhere from a year to 18 months. So that tightening, which has, in some cases, been historic in size, if not duration, is building in intensity and already having an impact.

As we move closer into the summer and into the fall of 2023, we'd expect the economy now to slide into recession. We assign something like 70% odds of a recession occurring in 2023, takes hold in the third or fourth quarter of the year, but then you get a rebound in 2024 as natural conditions start to ease again and interest rates ultimately come down.

As far as the intensity or depth and duration of that recession, most of call that something like a soft landing. You pass through zero your economy shrinks a bit, but not a lot. Our forecasts are looking for something a bit deeper than that, but not a lot deeper. However, when the economy is close to a zero rate of growth and interest rates are still high, it is vulnerable to shocks. We are certainly on the lookout for that.

The path back to a 2%, or an acceptable level of inflation, isn't going to be smooth. The direction is clear. We're now down toward 6%, headed probably below 4% over the next 12 months. But there will be twists and turns along the way.

The labour market remains very, very tight. This is most evident in supply-related or service-related sectors. Now, part of it has to do with labour market supply, which changed as we left the pandemic. But also, with individuals and families trying to take advantage of things that were denied to them during the pandemic, and especially during the lockdown phase. One only must look at airline prices or hotel rooms to see that that inflation rate continues to be high and difficult to break.

But you are well into a cycle of tightening. Money supply growth has slowed quite dramatically. We're starting to see the pressure on the economy and related slowing and inflation as a result. Having said all that, we do believe the path towards lower inflation is clear. It's been muddied a bit in the last two weeks with the fallout from difficulties at Silicon Valley Bank and concerns over other regional banks in the United States in particular. Until this point, the Fed had only one thing to worry about. With balance sheets strong at the household level, with employment strong, they could tighten without concern about the related impacts or collateral damage that tightening might deal out.

Central banks have dramatically shifted their policies over 2022 and into 2023. As inflation was rising, they moved from easing conditions to a dramatic tightening. These interest rates spike and slowing the rate of growth of the monetary aggregates. It is having an impact. Inflation is slowing and the economy will ultimately respond into the third and fourth quarter of this year.

The neutral level for interest rates, that level for interest rates that either pushes the economy forward or holds it back, is probably close to two and a half percent. We currently have a four-and three-quarter percent interest rate in the United States, using the Fed funds rate as the measure. It's clamping down on the economy and speeding through progressively every day now.

We think they peak at roughly five, five-and-a-quarter percent, probably hold rates there for a while, and that should allow inflation to fall back eventually towards the desired level of closer to two and a half percent. As irregular as that slowdown is going to be.

The past ten days, though, have been quite interesting for those who closely follow monetary policy, as we do. To this point, the Fed has only had one thing to worry about. And that's inflation, and the strength in family balance sheets, the strength in employment, allowed them to just attack inflation single mindedly without worrying about collateral damage in these other two areas because they were quite healthy.

Now, with the emerging weakness that we've seen, concerns in the regional banking system, in particular in the United States, that also has to worry about financial system stability. This isn't uncommon. It has typically happened in later rounds of Fed tightening. But it's another thing that should cap the level of interest rates at not too far above current levels.

The situation has been muddied a bit over the last two weeks.

Bond yields have risen quite sharply in 2023, alongside the boost in short-term interest rates. If we're right, short-term interest rates are near peak, and we're probably close to a peak, and maybe even past the peak rate for long bonds. We expect them to sell towards three-and-a-half, three and three-quarters, something like that over the next 12 months and stay in that range.

It's been quite remarkable, though, because we spent 40 years of progressively lower interest rates until they approached that zero bound in 2022. The correction in long bond yields has taken them up close to their average of the last 40 years. So that's a dramatic impact on the utility of fixed income investments in investment portfolios, the cash flows that they provide, their value as diversifying insurance against riskiness in equities.

While it's been a difficult market for fixed income investors, in some cases a historically difficult market, we really got somewhere. We've normalized interest rates. Our valuation models, for the first time in many years, show that bond yields are pretty much where they should be, and will move a bit lower, but not a lot lower in the next cycle.

The bear market of 2022 was all about valuations. Very simple: you drive inflation interest rates up, you drive P/E ratios lower. And P/E ratios, in some sectors, in particular mega-cap global technology, were above levels they should have been at anyway. Their growth rates simply didn't justify the levels of valuation they were trading at. But that's before. We think now that valuations are consistent with underlying inflation and interest rates in the economy.

The problem now becomes the economy itself. As we head towards a soft landing, we've got to think that corporate profits are going to suffer somewhat. And they might suffer because margins are above their norm and earnings themselves are above the trendline growth rates. 2023 is about what happens to earnings, not to valuations.

Unfortunately, analysts seem to have missed this. They were slow to cut as the economy approached a slowdown and now expect 2023 earnings to be essentially flat with 2022. If we do revert margins and we do revert earnings towards a longer-term trendline, as typically happens as the economy goes from growth to recession of any size, you could expect some downside in earnings. That puts pressure on the stock market going forward. Doesn't have to be big pressure, but it does cap the upside for stocks in the current environment.

Given the risks that that entails, [we] think it's better to sit closer to a neutral asset mix.

The bear market 2022/2023 in stocks has been exceptional. It’s challenging many secular trends that have been in place for a decade or more.

The first thing we've seen is a normalization of valuations. In the bond market, we think that yields are close to equilibrium or their long-term average of the post-war level. And that's just not yields, it's rates and it’s spreads, and has a dramatic impact on the utility of fixed income in portfolios. Much more useful at these levels of cash flows and as a diversifier against risk in equities than they have been at most points in the last decade or more.

The U.S. dollar is 11 or 12 years into a bull market. Bull markets in the dollar usually last eight to nine years at a maximum. We have an aging bull market in the U.S. dollar, [that] has now entered points of extreme valuation relative to many of its peers. This has been a key agent that's driven the U.S. markets higher relative to other world markets for the last 10 or 12 years and may be changing.

So regionally, where the U.S. stock market has led since the financial crisis, we have to keep an eye on cheaper markets that have demonstrated some degree of leadership during the recent bear phase. Europe, much cheaper than the United States, kind of binding in on relative strength. The same for Canada - was a much different list in the U.S. EAFE and emerging markets also could assume some leadership for the cycle ahead.

And finally, investment styles have really been challenged over the last six, seven months to a year. Where growth stocks, which received all the attention and most of the returns in the post-financial crisis era, suddenly value stocks much cheaper levels of valuation, have come to the fore during the bear market.

So why is this important? There is an old technical rule of thumb: if you want to know the leadership for the next bull market, just watch who's rising in relative strength in the preceding bear. And to U.S. dollar trades, regions outside of the United States, and value over growth have clearly shone during this bear market. We're watching them closely for leadership in the next bull.