The risk of recession is quite elevated right now and over the next couple of years. It’s the highest we’ve seen in quite some time, setting aside the worst of the pandemic. And it really is because a number of headwinds are conspiring against the economy all at once.

And one of those is, of course, very high inflation, which is encouraging people to spend less and making them poorer. Central banks are responding to that inflation with a lot of aggression. And rate hikes themselves hurt growth and also are associated with a high risk of recession in subsequent years.

You also have a commodity shock emanating from Russia and Ukraine, a China slowdown, and financial conditions are worse than they were. And financial conditions reflecting wider spreads, higher rates, weaker stock markets, and in turn hurting consumer sentiment.

And so for a number of reasons, the risk of recession is fairly high right now. Our growth forecasts do reflect that; they are below the consensus. They anticipate a fairly profound economic deceleration into 2023. And so we are effectively pricing in a higher risk of recession than the market is by virtue of those numbers.

Now continued growth is also possible. What you would need is a bit of good luck in terms of inflation, in terms of what’s happening in China, in terms of supply chains perhaps resolving a bit more quickly. You’d need businesses to stick with their fairly enthusiastic CapEx and hiring plans. You need consumers to keep spending, which they have been.

And so again, it takes a bit of good luck to avoid a bad outcome, but it’s certainly possible and needs to be a scenario, but recession scenarios also need to be considered quite carefully when trying to project the economy and markets going forward over the next few years.

Markets, of course, are not ignorant to that elevated recession risk. In fact, that’s a big reason why risk assets are materially weaker than they were in late 2021.

China’s nearly unique in the world right now in maintaining a zero-tolerance policy toward COVID-19, and that has meant locking down entire cities in China for weeks at a time when even a fairly small number of cases are detected. And that’s been a prominent story in Shenzhen. It’s been more recently in Shanghai.

This has been quite bad for the Chinese economy. It’s limited factories, it’s limited exports, consumption, and so on. And so we see a lot of weakness in the Chinese economy right now. Retail sales and auto demand is down outright from a year ago, which is almost unprecedented for China. Industrial production is also quite weak. This is nothing like the usual Chinese growth experience.

Now as Shanghai begins to reopen, there is scope for something of a rebound. However, we’re not at this point betting on a big economic bounce. And that’s in part because from a pandemic perspective, China could yet have to lock down other cities. It doesn’t seem to be about to abandon that zero-tolerance policy. And even if they don’t have to lock other cities down, people are behaving very cautiously on that risk. People don’t want to be stuck in their office or in a shopping mall or somewhere away from home if there were to be a snap lockdown.

China has other economic challenges as well. And so its housing market is still weakening, we think. It is very exposed to the global economy. So if global growth is slowing, not great for China. If the world starts buying fewer goods and starts shifting back to services, that’s not good for China’s goods exports. And the country is also cracking down on the tech sector. It has some challenging demographics as well.

So we’re still budgeting for weak growth by Chinese standards, less than 4.5% growth this year, less than 5% for 2023; pretty good by most country’s standards, not what China’s used to, and a bit of a drag on global growth just because we’re used to China helping a little bit more than this.

The war in Ukraine seems likely to continue for some time at this juncture. It’s unlikely to be fully resolved in 2022. And for that matter, from an economic standpoint, the question has less to do with when the war might be resolved, when sanctions might be lifted, and sanctions are likely to last even longer. In fact, historically, sanctions last for many years. If anything, sanctions are still intensifying as the EU recently restricted oil imports from Russia and Russia is now selectively blocking its natural gas exports to certain European countries.

And so that story of economic damage is likely to persist. It mainly operates through commodity prices, so many global commodities are now in short supply. Russia, and to a lesser extent, Belarus and Ukraine, are big exporters of oil and gas and wheat and potash and some metals, et cetera. And so there are negative commodity shocks in all of those spaces in an economic parlance.

And when we tally this up, we think that this chops between half a percentage point and a full percentage point from global growth over the next year or so. And that’s a very significant effect.

The damage is up to 3 times that when we’re talking about Europe specifically, given its proximity and energy orientation toward Russia. The damage is somewhat less in the U.S.; even less in Canada, given that Canada happens to be fairly wealthy in its own sense in those particular resources.

Under normal circumstances, a shock of this sort might be enough to almost create a global recession. It would likely be enough to create a recession in Europe. Those risks are absolutely elevated, and other forces are also pointing in that direction, but it just happened to be the case that Europe was set to grow by about 4% in 2022 before this happened. And so I wouldn’t say that this is a recessionary shock by itself, but it’s one of a number of factors that does leave an elevated risk, particularly for Europe.

It’s also worth spending a moment thinking about the longer-term implications of all of this. And so the world is fracturing into different cliques, and that’s certainly true in the Russian case. It predates Russia to the extent that China has become a global power, and frictions have emerged versus the West as well on that front. It suggests more military spending, less spending, therefore, on other programs, less globalization, perhaps, in particular, and not a great thing for the global economy over the long run. It’s a bit of a drag, a bit of a friction over the long run.

Inflation is extraordinarily high right now, the highest it’s been in many decades. And so it’s critical that it does come down. And fortunately, we do think inflation isn’t that far from peaking; a number of forces suggest that.

And so for instance, supply chains are beginning to improve a small amount. And supply chain problems played a larger role than many people recognize in driving high inflation, so that’s quite useful.

Commodity prices, well, they’re still high, they may even still be rising, but keep in mind, they would need to rise aggressively over the next year to keep inflation percolating at the kind of levels it’s at right now. And that seems fairly unlikely.

And we can see some of the early inflation movers starting to turn lower. And so for instance, car prices finally beginning to soften after a big run higher. We suspect dwelling costs will soften somewhat as well as interest rates go up.

We can see that inflation expectations are actually becoming a little bit less high. And similarly, consumers are becoming more price sensitive, which maybe isn’t great for the economy, but is quite good for limiting the extent to which businesses continue to send prices higher.

The economy, of course, seems to be weakening as well. And so that will help inflation come down too.

So we do think inflation gets to come down, but perhaps only gradually. And I wouldn’t want to neglect the fact that there are some second-round inflation pressures that exist that will prevent, we think, inflation from normalizing all that quickly.

And one of them is just that the labour market is now so tight, wage pressures are percolating. Inflation has become so broad, so many different products have a high rate of inflation. It takes longer to solve. It’s harder to put that genie back in the bottle.

And so we think inflation’s not far from peaking, but it takes some time for inflation to fall back to truly normal levels. And actually, we’re not convinced inflation gets back to low levels as it was before the pandemic over the long run. We think there are some extra forces that might keep it a little over 2%.

Interest rates are rising with unusual rapidity right now, mostly on the back of central bank actions. And indeed, central banks in North America are raising rates about 4 times faster than usual, by twice as large increments as normal and twice as frequently as usual. So this is quite an unusual tightening cycle.

And interest rates look likely to rise beyond what is conventionally deemed a neutral level. In fact, they’re likely to rise to levels that are unfamiliar over the last decade or so. And so this is quite a central story to the economy right now.

These actions should help to lower inflation; that’s why they’re taking place. So that’s a good thing. They should slow the economy, which of course is less desirable, but arguably inevitable, given what interest rate hikes generally do. And, of course, it should particularly slow interest-rate-sensitive sectors like housing.

And so housing does face some particularly aggressive headwinds right now. Higher rates, of course, hurt affordability for people with mortgages. Affordability was already deteriorating even before that on the basis of the big run-up in house prices in many global markets over the last few years. Add in the prospect of what could be a weaker economy and we should see cooler housing markets across most of the developed world.

Canada may be more affected than most by virtue of significantly worse affordability. That’s been a brewing story for a couple of decades now. Higher levels of household debt in Canada than in many other markets. And also some regulatory changes that could reduce demand and increase housing supply, which also hurts home prices.

Yes, immigration is set to be strong in Canada; that’s a helpful thing. But on balance, we budget for diminished housing demand in Canada; a moderate, outright decline in Canadian home prices. So home prices more likely to fall than not, we think, but not global financial style contagion. We really don’t see that many parallels to the U.S. experience of the late 2000s. A weaker housing market certainly would weigh on growth in the usual sectors, but perhaps not to the extent of creating broader financial distress.