The central economic problem right now is that inflation is much too high, and that's bad in the sense that it distorts the economy and economic decisions. It's also making, maybe even more prominently, central banks raise rates aggressively into levels that we haven't seen in well over a decade, and that hurts the economy quite significantly as well. And so inflation matters a lot.

I think the natural starting point is to ask, why is inflation so high? And the short answer is that it's no single thing. In fact, you'd struggled to find a single thing that could push inflation up to the seven and eight and nine and 10% type levels. We think it's actually multiple forces that have been at work, including supply chain problems, a big commodity shock.

Too much stimulus from central banks and perhaps too much stimulus from fiscal authorities as well. And the good news is, as we look at those four drivers, we have actually seen them all turn in an important way. And so supply chains are improving quite significantly, though they are still somewhat imperfect. Commodity prices have fallen fairly substantially, not low prices, but they have begun to fall, which is a reversal.

Monetary stimulus has turned quite profoundly, and we think central banks are getting closer to the finish line. They've moved well beyond stimulative mode, into outright restrictive mode. And there is a subtle fiscal drag as well. And so in turn, inflation is now starting to fall. We believe it peaked in around June in North America. It likely peaked in October in Europe and the U.K. And as much as we expect a further decline, it's probably not going to be a rapid or smooth decline.

There will be some choppiness. And we are still dealing with things like rapid wage growth and inflation that is just so broad that it takes longer to solve. But nevertheless, we think inflation can continue to fall. And actually we have a below consensus inflation forecast. We can see that businesses are changing their pricing behavior. We can see China, Chinese producer prices starting to fall.

And so inflation likely can fall perhaps more than the market is currently assuming. And that's a fairly big deal. Inflation's been the biggest problem over the last year.

We forecast a recession for the developed world in 2023, and that's simply because there are far more economic headwinds than tailwinds. And that includes the corrosive effect of inflation, which likely remains high for a little bit longer.

Significant interest rate hikes, which do damage to growth, but also high gas prices, a struggling Chinese economy and so on. And so realistically, that does add up to a recession lasting a few quarters across 2023. We do also find when we cross-check this, that the majority of simple recession signals that we monitor are also showing recession, including the fact that yield curves are now inverted and our business cycle work similarly makes the conclusion that we're likely at an end of cycle moment, which is normally associated with a recession arriving within several quarters.

So recession more likely than not, not with 100% certainty, but with good luck could allow growth to remain in 2023. But we give it something like an 80% likelihood. We think a decline would be of a middling magnitude, which is little deeper than the market is assuming right now, though not as deep as the last two recessions.

And I guess the way to think about this isn't just that a recession is likely, but there are perhaps some silver linings or redeeming values to it. And so we think as an example, this could be a more useful recession than usual. It should help to tame inflation, which is job one. If we want to enjoy rising prosperity for the next few decades, it should help to right-size housing markets, which would be good from a societal perspective and should take some heat out of what is arguably an unsustainable labour market as well.

And it might also feel a little bit milder than it actually is, given that we don't expect to see job losses on the scale of normal recessions as companies hang on to workers they fought so hard to find. It's also worth recognizing recessions are not forever. They last a few quarters, and in this particular case, we think it actually sets up growth for a fairly robust period of expansion over the subsequent several years.

And classically, there are also good investment opportunities that arise during economic downturns and indeed the valuations that we see today are already at least partially reflecting that.

It’s worth spending a moment on the global growth outlook. And so we believe developed nations are most likely to succumb to outright recession. The U.S. probably suffers a little less than most, just in the sense that it's a less interest rate sensitive economy right now.

Canada shrinks a bit more than the U.S. It is more rate sensitive, in particular due to its exposure to an overheated housing market. And then Europe and the U.K. likely fare a little bit worse again. And that's because of their exposure to Russian sanctions and in particular high natural gas prices with perhaps a pinch of Brexit and political chaos in the case of the U.K.

So not all recessions exactly alike. Emerging market growth should also be significantly affected in similar ways in terms of slower growth in 2023. In fact, globally we're looking for only around 2% GDP growth for the year ahead. And that's right around actually the theoretical threshold for recession or not on the global level. Global economy rarely shrinks.

2% is considered a pretty bad number. China is worth singling out, though, just because it is marching to its own drummer to some extent on multiple fronts. So it suffers from some unique challenges that other countries do not, in part though, because it actually could grow a little bit faster in 2023 than 2022 and so I guess the main story is one in which China's zero tolerance policy has devastated the economy's growth.

We can even see that hitting right now, given a recent wave in China. But protests have mounted in a big way. And China is now seriously revisiting some of those COVID rules, though not abandoning them altogether. This should allow the economy to move a little bit more freely, though they are balancing that versus the risk of the virus growing out of control.

Growth, we think right now, is running around 3% for China, and so that is significantly less than normal. China's economy is also facing housing market challenges and a government that's shifting control from the private sector back to the state, which probably isn't growth- maximizing. But as we look out over the coming year, likely fewer COVID restrictions, likely some resolution of the most severe headwinds for the housing market as housing policies start to ease as well.

I wouldn't want to overstate how quickly China can run because it has growing debt, it has poor demographics. It isn't emphasizing the private sector to the extent that would be optimal. And so we think the Chinese economy picks up next year, but likely no more than about 4% growth. And for context, historically, China would grow at 6% plus before the pandemic.

They're likely now in a 3 to 4% world.

U.S. midterm elections yielded a divided Congress. Democrats have hung on to the Senate, even added one critical seat, and the Republicans in turn claim the House of Representatives from the Democrats. So it's no longer a Democratic sweep. It is now very much a divided Congress that limits the legislation going forward over the next few years.

To be sure, the Democrats can still do things. They can dominate committees, they can appoint as-needed Supreme Court justices. There is room for executive orders from the president and so on. But in terms of major legislative achievements, there is not a lot of scope for that. Markets actually usually like a divided Congress and limits, I suppose, how much trouble politicians can get into.

And this could be important going forward to the extent that the fiscal environment is changing in a way that makes the bond market less tolerant of fiscal excesses. And so perhaps the U.S. is less at risk of running into those sorts of problems. Bond market is caring more about government borrowing and government financing, in part because public debt is high and rising, in part because central banks are no longer absorbing much of that debt as quantitative easing has ended and even reversed.

And in part just because borrowing costs are going up, it's making everything more expensive for governments. This is a tricky time, though, because you've got the bond market more sensitive, less tolerant of all this borrowing, and yet governments will probably want to provide some support during the next downturn. And it's tricky as well because we think structurally this may be an era of big government.

You have big energy subsidies happening right now; pressures to increase military spending in a more dangerous geopolitical world; rising spending obligations for aging populations; green spending; as deglobalization happens, more spending on industrial policy. And so I guess the story is one in which governments would like to spend a lot bond markets don't want them to. It could be interesting.

At a minimum, there should be more differentiation between well-behaved and poorly-behaved sovereigns.

Housing markets are the most affected sector of the economy when interest rates are rising. And so it's no surprise that many housing markets are now suffering. Canada's is particularly vulnerable due to especially high household debt and especially poor housing affordability. And going into the pandemic, affordability wasn't great.

It got worse as prices soared through the pandemic and has since become even worse as mortgage rates have more recently risen. We've accordingly seen weakness manifest. And so housing resales in Canada have been falling and plans to build are beginning to ebb and home prices are in outright decline. And to the extent the economy is likely to weaken over the next year, that would argue for further housing weakness again.

To be sure, Canada is planning big immigration numbers in a way that should provide an undercurrent of support for housing demand. It is fair to say there are significant supply constraints on housing with green belts and zoning rules and things that again suggest that home prices don't need to fully retrace. But nevertheless, from a home price perspective, we think there is likely further to fall.

We've seen about a 10% decline in national home prices so far. We're assuming 20 to 25% is a reasonable cumulative decline. So about half done. I will admit there is huge uncertainty around that prediction. There has, for example, been some stabilization recently. Maybe a best case scenario was that was it. But 20 to 25% decline isn't that much relative to the price increases that occurred earlier in the pandemic.

It's not that much relative to the affordability mismatch that's in place right now, let alone given that mortgage rates are higher than normal. And so we're predicting some further weakness. It is likely to remain a source of softness for the economy in general. Though I should emphasize not in a way that induces significant financial market stress. Canadian mortgage market rules are such that a reprieve of a 2008 type of experience seems quite unlikely at this point.