We’ve held our GDP forecast a bit below consensus for many, many quarters now, and that’s proven to be the right direction. But the slowdown is intensifying. There are a variety of threats that the economy is encountering and the pathways to a bad outcome, a hard landing, I think can’t be denied. That’s not our actual forecast, but we need to consider how deep might this economy slide to.

So we have unacceptably high levels of inflation, and this really dominates the forecast outlook. But there are other pressures on the economy as well. There’s been an aggressive round of central bank tightening around the world has only just been touched off, and it’s got a long way to go before it’s finished. So there’s general tightening of financial conditions that will gradually intensify over the next year to 18 months and take a round out of the economy.

There’s been a commodity shock on the back of Russia’s invasion of Ukraine. And it’s worked through, not just commodities that are directly affected, but a whole raft of important elements that contribute to consumer prices.

The supply chain challenges that have been with us since the reopening of the economy are perhaps lifting a little less intense than they have been, but they’re still there. And of course, the things that have really created the supply chain challenges have been on-and-off openings and closings of the economy and the disruption that that causes, and China has been a major element of that. And certainly, China’s zero-COVID policy, while there’s been some good news on that in the last few days, is still a fairly strict clamp on a full opening of the economy, global economy, and an elimination of supply chain issues.

So when you take all of these things together, this murkier outlook, and as I said a moment ago, more pathways to negative outcomes than we’ve dealt with for a very, very long period of time. Our own forecasts look for something like 2.5% growth for the developed world in 2022. But as these challenges, in particular, financial condition tightening and rising of interest rates, 2023 looks to be even weaker, perhaps something as low as 1.3, 1.5% for the developed world. And really, this will be the lowest growth that we’ve seen for more than a decade and an important challenge to the economy.

I think there’s little question amongst economists and investors that inflation, particularly near its 8% level in the United States and similar levels around the world, is the single most important challenge facing central bankers and the economy as a whole.

For four decades, central banks have built credibility around their ability to hold inflation at levels that engender long-term economic growth. And that’s at risk. There’s a variety of things that are holding inflation up. We believe that they will pass, but it is a threat. And major action has been started and will continue until it is brought under control. And the cost might be a bigger slowdown than we had initially expected.

The supply chain disruption is ongoing. There is the invasion of Ukraine by Russia that has spiked the commodity prices. Simply the opening up of the economy and shifting from things that we demanded as consumers during the lockdown phase to things that we want to do now that we’re back to a more normal lifestyle have created pinch points in the economy. Things like used car prices at one point were up as high as 54% on a year-on-year basis.

Now, fortunately, we’re starting to see some easing on some of these factors. It might be that the Fed missed its chance to get ahead of the curve. But by starting to raise rates as they did last quarter, and aggressively raising rates—50 basis point hikes as opposed to the normal 25 basis points—they’re making it clear that they’re probably going to end up closer to what they consider a neutral rate, and we think that neutral rate is closer to 2.75% and 3%. All those things are having an impact on the psychology of investors and consumers. And that’s, of course, why they do that.

It is having a measurable impact. We can see, for example, those car prices I mentioned are no longer up 54%, are up 10% on a year-on-year basis, but still only 6% off of their highs. Lumber prices have crashed, down 66% from their peak. There are still, though, generally rising commodity prices, and as I said, much more action is going to be required over the coming months and maybe even to 2023.

Central banks are responding aggressively against the inflation threat. There’s no question that 40 years of hard-earned credibility, earning their inflation or anti-inflation credentials, are at risk. And low, stable inflation is critical to stable long-term growth of the global economy and improvement of living standards everywhere.

I think as a result of that, that the aggressive program that the Fed has begun, followed by other central bankers—the Bank of England, Bank of Canada, and the rest—is going to continue throughout the rest of 2022 and into 2023. And frankly, it’s going to continue until they win this war.

Usually, they hike rates at about 25 basis points a time. This time, the Fed and Bank of Canada has hiked 50 basis points. And we’ll see probably several more of those, at least from the Fed, in the near term, and trying to get that rate towards what’s considered to be neutral. At that point, you no longer have an interest rate that feeds growth; you have one that is neutral and not restricting or feeding. But it seems almost irresponsible to leave in place an aggressive or a positive interest rate policy during a period of unacceptably high inflation.

Alongside rate hikes, we’re likely to see a continuation of quantitative tightening. This is a reversal of the bond buying program that the Fed and other central banks put in place to manage down interest rates during the pandemic and the recovery from it.

So there’s a bunch of factors that come together to tighten monetary conditions and are likely to play out and could even intensify as we move towards the end of 2022 and into 2023.

Our own forecast looks for something like a 2.75% short rate in the United States. It’s very close to the consensus of 3% and also the 3% level that many of us consider to be neutral, and it seems that the Fed would consider to be neutral, in that range as well. So there certainly is at least a year of financial conditions tightening that lies ahead.

For a long time, we’ve been very concerned about the sustainability of ultra-low interest rates. The real rate of interest, the after-inflation rate of interest, had sunk to historic low levels. When we say historic, we mean over 100, 150 years-type historic. That was clearly unsustainable when the pandemic moved away and people got back to demanding a proper payment after inflation for saving versus spending.

Well, the rise in inflation has actually neutralized that or more than neutralized that. But the tightening of Fed policy that began just last quarter, coupled with concerns over future levels of inflation, have actually resulted in one of the worst bear markets in bonds in modern history. Over the last several months, yields in the United States have moved from 1.5% on a 10-year T-bond—that’s the world’s base rate of interest at that maturity—to 3%. So basically, a doubling of interest rates in a very short period of time.

It’s interesting to us, though, on our models that that 3% rate removes much of the valuation risk that we had been so concerned of for so many years. 3% is interesting to us also because, in past cycles, yields have tended to peak, stop going up around the level that short-term interest rates stop going up. If the neutral rate for Fed funds is actually close to 3%, then we could already be quite near the final peak for bond yields for the cycle.

We look for yields of around 3% a year from now, which means that your total return between here and there, something like 3%. You get to keep your coupon. Although, admittedly, it could be quite a bumpy ride along the way as we get used to this tightening of financial conditions that we’re dealing with.

It certainly has been a bumpy two quarters for the equity markets after setting new highs and especially the United States and the Nasdaq soaring away over the last year. Many markets have actually recorded bear markets, with that being declines of more than 20%. The Nasdaq, for example, with its high valuations, hit particularly hard, down 35%. The S&P 500, on an intraday basis, down just a little over 20%, although it hasn’t closed on a daily closing basis below 20%. I think we can call that a bear market. Canada has actually been among the best, heavily weighted in commodities, which actually benefitted from some of the negative turns in the economy.

It’s interesting to note that virtually all of the correction so far has nothing to do with earnings or earnings expectations for companies. As you raise interest rates, valuations come under pressure. Now valuations were very, very high as this negative turn came for the economy. So the first step was we had to get valuations down from a level that was expecting too long a period of too good a time to levels that were completely normal in current conditions of interest rates and inflation. So that knocked about 6 or 7 multiple points off of the S&P 500; a little less off the rest of the world where multiples weren’t quite as high.

And then, of course, we had the big spike in inflation and interest rates; that knocked a couple of other multiple points off of what was sustainable. But it really explains the full amount of the correction that we’ve seen from here. In fact, analysts around the world are still looking for a high single-digit or low double-digit growth in corporate profits. This is in the face of an economy that’s slowing and where margins are at record highs. One has to believe that the earnings are coming under some threat.

Now, if we went into a full-blown recession—and again, that’s not our baseline forecast, but of course it is a possibility as this is still a developing situation—you could see earnings fall as much as 25% from here. There’s no reason to expect that the average is what you’re tied into. But that does give you a sense of the scale of what tends to happen as the economy hits the rocks.

If that does happen, we can look for more weakness in equities. If, on the other hand, inflation has peaked, and there’s some evidence of that, if it’s not peaking here, if it hasn’t done so already, it could be in the near term, that the market has fully priced in the rate hikes and quantitative tightening that we’re almost certain to see over the next year, then valuations have no further to fall. Stocks should stabilize and, in fact, provide single-digit returns out over the next year. But certainly, there is a wider range of outcomes possible today for the stock market than there has been in most environments over the last 10 to 15 years.

It doesn’t feel like a good time to be carrying higher-than-normal risk.