Global economy is about to feel the maximum pain from almost 2 years of pretty incredible tightening in terms of rising interest rates pretty much everywhere, a decline in the rate of growth of the domestic money supply and even the removal of prior quantitative easing. This was all designed by the Fed and other central bankers to bring inflation down to an optimal level; 2%, 2.5%. But the full bite hasn't been felt until now.

Typically takes about 22 months after the beginning of tightening for that to show up in the economy. And while we kind of grew bored waiting for that recession to come, actually the window is just now opening. We'd expect the U.S. economy to pass through some kind of a mild recession, at least by the first quarter of 2024, second quarter of 2024.

But we see in other countries Canada, the United Kingdom, Germany, that the economy has long since started to suffer, passing through some kind of a technical recession, at the very least right now.

In a sense, the slowdowns that we're already seeing in the economies of the United Kingdom, Canada, Germany, gives the Fed a look ahead of what will happen in the United States if rates are left at this high level over a considerably longer period.

So, there is some pressure to finish this round of tightening unless it's absolutely necessary to finish the job on inflation.

We need to remember that the goal of central banks wasn't to put the economy into recession through a tightening of monetary conditions. It was to arrest the rate of growth of inflation, which had grown to unacceptable levels. And more and more, that looks to have been accomplished.

So inflation peaked year ago at 8 to 9% in most countries, a little higher in some parts of Europe, but it's now down into single digits and well below 5%. And on a path towards 2.5, 2% by the end of 2024, early 2025.

And with any economic indicators, these paths are irregular, but the direction we think is now fairly firm towards that 2% level. You could look at some of the early pressures that were on inflation, for example, supply chain issues that arose during the pandemic, massive growth of the M2 money supply, big increases in rents and so many people have suffered through.

And almost universally, these things are now on a path down towards where they came from before the pandemic. And inflation is following.

it's becoming increasingly apparent that the tightening of central bank policy, not just in the United States but around the world, has delivered the goods. The question really is, is how soon will they begin cutting? Now, if you look at a normal road map, we look at recessions or recession like conditions all the way back to the middle of the 1950s, a lot of data to look at, takes about 22 months from the beginning of tightening for recession to set up.

So, whether or not recession actually happens, this time, because there are changes in the economy, this suggest that maybe we could avoid that, but perhaps not by much. But the window opens for that recession around Christmas of this year, early 2024. Eight months before that recession has taken hold in the past at median, rates have stopped rising.

Rates stopped rising, it seems now in July of this year, which is consistent with that roadmap. Four months after rates stopped rising, the Fed typically begins cutting interest rates. Now, it's slightly like they're going to cut interest rates before 2024, really in the spring. And that's when we would look for that. But it's interesting that usually that happens four months before the recession takes hold and the maximum intensity policy takes hold, which I said is early in 2024, you tend to see a peak in bond yields also four months before the recession takes hold.

And that's kind of in the time window that we're in right now. Now, in the last several days, we've seen a big decline in bond yields as more and more investors and forecasters got onto the view that, whether or not the economy goes through recession isn't really an issue for fixed income markets. The question is, was there enough tightening to deliver to bring inflation to its knees, put it on a firm path towards 2%, and that now appears likely.

We've seen almost 100 basis point decline in 10-year yields in the United States, 1 full percent, from 5% to very close to 4% in the space of only a couple of weeks. The markets are now saying that Fed tightening is done and beginning to look ahead to easing of conditions some time in 2024.

For a very long time, we've had concerns over the sustainability of interest rates, and we move down to a 1.5% long term bond yield during the pandemic. In the context of 150 years of interest rate history, we had never been at those levels. We're concerned about the chance of an acute move higher in interest rates as we had to deal with valuations in almost any reasonable economic scenario going forward.

Of course, we pass through in 2023 one of the worst bear markets in all time history, and not just modern history. Valuations have been addressed. We've moved from being below equilibrium to slightly above equilibrium. Inflation now on track towards 2%, and real rates of interest or after inflation rates of interest, have moved from being deeply negative up to the 0 to 1% range that we'd expect to be sustained through the next economic cycle.

Our biggest concerns that have held us underweight fixed income securities for so long, have largely been removed and replaced with a reasonable to attractive valuation backdrop. There’re also technical considerations that help us with timing this. We had a huge amount of bearishness. In a contrarian sense, that usually sets up the chance for a pretty good rally. Year over year rates, a change of bond yields, had moved to levels we'd never seen before and are now backing off for another good buy signal.

A long-term price momentum, another technical indicator we look at, also positive for further gains in the bond market. As a result, for the first time in a decade or thereabouts, we've moved from underweight fixed income to slightly overweight fixed income in our recommended asset mix. As we look for yields in the United States to move from the current levels in the low to mid 4% range towards 3.5% to 4% over the year ahead.

You earn your coupon, and perhaps move it there for capital gains as well.

With considerably less clarity in the equity markets going forward than to us, we feel with the fixed income market. It's been quite an interesting year in 2023 and the last part of 2022. And while the U.S. stock market seemed to take off, it was really just seven stocks that led it.

If you look at the end weighted average, you're up low single digits versus almost 20% if you look at the S&P 500, which is somewhat dominated by the Mag 7. You look at global markets, pretty much low single digit returns there, not just in Canada, but in European Asian exchanges as well.

What that means is that valuations, because earnings grew through the period, have been addressed. Where we had fairly expansive stocks leading into 2023, they're actually quite attractively priced in many countries outside of the United States. And in fact, if you take the Mag 7 out of the United States index and you see even in the United States, stocks are at fairly attractive valuation levels.

That was a concern for us leading into 2023. It's no longer a problem. The issue, though, is the economy. Stocks are much more dependent on avoiding recession or at least eking out some kind of growth in order to drive corporate profits S&P earnings. If we pass through recession, those earnings are likely to drop or at least stall out.

And stocks will probably have some downside from here. If, in fact, though, we're able to avoid recession, there is the case that stocks could mount to continue the rally that they've been in and, trade somewhere between 4,500 and 5,000 over the year ahead. But of course, dependent on, do we enter recession, is that recession mild or median, and what effect will that be on corporate profits.

This is a fascinating time in capital markets everywhere. There is $6 trillion dollars of cash that's sitting on the sidelines in the United States. If short term interest rates have peaked, and we think they have, investors need to consider repositioning that cash into risk assets.

Yields will fall further. Eventually, stocks will rise either in the near term, but certainly in the intermediate term, as the pressure on the economy fades later into 2024. It's the time to look closely at what one's asset mix is. While we've been able to almost hide out in high yielding cash investments for the first time in 15 years, that window is starting to close and short-term interest rates could fall quite rapidly through 2024.

Our recommended asset mix for a global balanced investor now runs with only 1.5% cash. Very low cash. And really, they're sitting there opportunistically. We're slightly overweight fixed income and market weight or neutral weight in equities.

The changes that we've seen in capital markets over the last 18 months have changed the way we ought to look at building investment portfolios. At a 1.5% bond yield, fixed income assets didn't do much for portfolio construction. They didn't provide much in the way of cash flows to investors. They ended up with bonds very highly correlated with equities and not providing a risk cushion against risk seeking assets that you would typically have in equities.

But now at a 4, 4.5% interest rate, fixed income assets have the utility that they used to have in a blended portfolio. We think investors ought to take advantage of that. If we look at the long term returns that one could expect when they're building their portfolios, putting a 40% fixed income position together with a 60% equity position 18 months ago would have yielded something like 5% returns for the market, based on our own forecast for the long term.

Because interest rates have risen from 1.5% to 4%, 4.5% in some places, that long term return potential has now moved up from 5% to 6.5%, 7%, much closer to levels that investors typically embed in their investment plans. We've represented with an opportunity to build portfolios much more efficiently now than we have in a very long period of time.