Of course, it’s always possible that our base-case scenario turns out to be aggressive. There are a variety of threats that could push this economy off of the even keel that it’s found itself on. Whether it’s Omicron or another variant, anything that feeds the pandemic will destabilize the economy and take something out of growth.

China is slowing anyway, facing re-regulation and a mountain of debt in its property sector.

Inflation is running hot, certainly far hotter than ourselves and forecasters and even central bankers had expected. In fact, the Fed has even said, maybe we shouldn’t be using the word transitory. If it proves more pernicious, eventually, a more severe central bank response will be necessary, and that in itself is a bit of a risk.

Right now, we think inflation will cool, that central banks will be able to move towards a calm, measured, well-telegraphed tightening monetary conditions. In fact, that tightening has already begun, beginning with the removal of quantitative easing. But if inflation turns out to be a bigger problem, faster, more destabilizing rate hikes will come, and that will knock us off our base-case scenario.

So, we’re not without things to worry about, even though we look for still reasonably strong growth in 2022.

Inflation has to be amongst the greatest worries as we head into 2022. Most of us had expected a calming of inflation as we move further out of the pandemic and you reached a more of a balanced economic situation. That really hasn’t happened.

Now it can be blamed on supply chain disruptions. It could be blamed on specific events that happened during the pandemic. But frankly, it’s broadened out from there. And we need to be very, very careful about inflation expectations.

If we look at market indicators of inflation expectations—and they’ve moved up a bit for the near term—fortunately, the degree they’ve moved up for in the long term, they’ve just sort of moved from being too low to a normal level.

What’s happened so far are the combination of supply chain disruptions and much more rapid comeback of the consumer sector, which wasn’t matched by employment. There just weren’t enough people to take all the jobs that were needed.

As that calms, you move past the short term into the long term. Nominal growth conditions move to a more sustainable pace. We expect to see inflation move down, but that’s not in the near term. The longer that they stay up, the more threat there is that long-term inflation expectations change. Right now, we look for inflation of, say, 4.5% in the United States over the coming 12 months and, say, 3.8%, and then continuing to fall in the United States and in Canada beyond that.

We need to also remember that, when we move from the short term to the long term, when the pandemic is no longer the important issue, supply chain disruptions have been sorted—we’re facing some pretty considerable downward pressure on inflation. The demographics of the world argue that, for the very long term, that the greater fears won’t be too much pressure to the upside but perhaps not enough. The balance of those should lead us back towards something like a 2% inflation rate over the longer term.

We had a bit of a volatile bond market as we closed out 2021. Most of the rise in yields, though, has been confined to the short end of the yield curve as investors anticipate a tightening of monetary conditions heading into 2022 and beyond.

Nevertheless, with yields at below 1.5% on, say, a 10-year T-bond yield, the world’s most important and trendsetting bond, we could look for a further upside pressure into next year.

Real rates of interest, or the after-inflation rate of interest, is actually at a historically low level, almost minus 2%. So that’s going to likely go at least to 0% over the cycle ahead. And when you don’t do that through a decline in inflation, you add a 200-basis-point or full 2% increase in real rates, you’ve got a real problem in the bond market at some point. And that’s, again, why inflation is a particularly important indicator to watch.

We right now don’t think that’s likely. We think inflation comes down, allowing real rates to drift up and yields to move from something like 1.5% to, say, 1.8%, 2% in Canada and the United States over the coming 12 months. But the great risk here is inflation stays hot and real rates rise, and the damage in the bond market could be more significant. We think that’s unlikely, but a possibility.

Many equity indices actually went on to new highs in 2021, to the delight and surprise of many. The U.S. market in particular is up 21% so far this year. Another great year for stocks and led by large-cap technology. And really, the U.S. stock market trumped all others, though Canada had a very good year as well.

So you go into 2022, conditions are somewhat different. Valuations or price-earnings ratios are particularly high in North America, and so they’re very demanding as far as the requirement for profit growth to keep this bull market alive. Much less so outside of North America, where returns have been much more moderate and P/Es are, therefore, much lower.

So when you look at what kind of numbers are required in North America to provide for another reasonable year for equity gains, you’re going to have something like 22, 23 times earnings in the United States. And our models say that, given current and expected interest rates and corporate profitability, you should probably be trading at a neutral level, not too high, not too low, be closer to 19. So you might be something like 3 multiple points too high. We don’t necessarily have to go back to a neutral level of valuation.

Will we get the corporate profit growth to sustain, though? We can’t have surprises when you’re at a high level of valuation.

If we look at a simple model that says, how much nominal growth are you going to get in the economy, and how much revenues and earnings would typically be pumped out at that, right now, our nominal growth expectation would provide for 18% profit gains again in the United States in 2022 over 2021, and 2021 was up almost 50%. So this is massive.

Now the consensus right now looks for 8% profit gains. But given that the economy looks like it could produce almost twice that, and given that 80% or more of earnings releases are coming in above the consensus, it’s entirely possible that, yes, we will have a good year for profits, you will be able to sustain P/Es, maybe not at the 22 or 23 they’re at, but say somewhere between 18 and 20. You put all that together, you could see single-digit gains, high single-digit gains even, for the S&P 500; other markets, which would have even greater potential because of the lower valuations.

So how have we handled that? Well, the opportunity set I think is lower as we head into 2022 than it’s been at any point since the pandemic, if only because valuations are higher and markets have come a long way. We think the opportunity set is actually not very attractive at all in fixed income markets where, one way or another, we think that yields will drift higher and pretty much wipe out your coupon.

So we’ve run risk weightings biased towards holding risky assets, overweighting or above-neutral positions in equities for quite a long time. And we’ve been taking them down a bit lately, but still are above a neutral weight. And we remain below our neutral exposure or our normal long-term exposure to fixed income assets. We’ve built a bit of a cash reserve, using that should volatility take stocks lower.