– We do not expect permanent destruction of demand from this wave of Covid, but rather a delay in reopening and economic normalization. In fact, a growing number of indicators point to a turning point in the Delta variant. As Covid continues to subside, strong momentum should continue into 2022 as companies begin to rebuild depleted inventories and increase capital spending. Central bank policies should remain growth-oriented, and even China's slowdown is likely to be offset soon by a policy shift.

– Although growth is slowing and inflation is rising, we do not foresee a scenario of "stagflation," as demand remains strong and financial conditions remain loose.

– In our base case, we will continue to see higher inflation, but also higher growth, and this has important implications for the market. A stagflation portfolio should be overweight in commodities, neutral in equities, and underweight in bonds. In contrast, a more inflationary portfolio should be overweight in commodities and equities and more aggressively underweight in bonds.

– In this context, risk assets would continue to perform well and bond yields appear to be finding a floor, which is generally a good omen for cyclical value leadership.

– We see a lot of emphasis on high equity valuations, but little mention of the unattractive nature of base rates and corporate spreads, with little room for compression. Bonds appear to be more disconnected from fundamentals and will therefore be more vulnerable to inflation and policy risk.

– In this regard, we believe that the correct approach is to continue overweighting equities over fixed income, where relative valuations continue to offer a large premium for their history and equities are the only asset class that produces positive real returns and tends to perform well in a higher inflation environment, while for fixed income we recommend a conservative approach in terms of duration.

– Is an aggressive Fed a problem for stock markets?One channel through which a more aggressive Fed could hurt stocks is via an increase in real rates, as higher real yields reduce the relative valuation advantage of stocks versus bonds. However, we continue to find it difficult to characterize stocks as expensive when real yields remain so negative, with the 10-year real UST at -88 bp. This level of real yields implies an equity risk premium of around 5.3% currently for the S&P 500. In the previous correction in 2015 and 2018, the equity risk premium bottomed at 4.5%. So, mechanically, we would need to see the 10-year real yield increase by 80 basis points from here for equity risk premiums to decline to 4.5%.

– Finally, while the dollar continues to rise to a new high for the year due to growth fears and a more aggressive Fed, we believe that these growth fears are exaggerated and that the Fed will not be alone in responding to inflation and shifting to a more aggressive stance. In fact, in the medium term, we see a risk that the ECB will follow the Fed's lead, putting upward pressure on both European rates and the euro.

For more information, we invite you to view our Monthly Economic and Market Outlook (1) and International Investment Proposal (1) reports.

Humberto Mora

Strategy and Investments