– We do not expect this wave of COVID-19 to cause a permanent decline in demand, but rather a delay in the reopening and economic normalization. In fact, a growing number of indicators point to a turning point for the Delta variant. As long as COVID-19 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 the slowdown in China will likely be offset soon by a policy shift.

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

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

– In this context, risky assets would continue to perform well, and bond yields appear to be bottoming out, which generally bodes well for cyclical value leaders.

– We see a lot of focus on high equity valuations, but little is said about the unattractive nature of base rates and corporate spreads, which have little room to narrow. Bonds appear to be more disconnected from fundamentals and will therefore be more vulnerable to inflation and policy risk.

– In this regard, we believe the correct approach is to continue overweighting equities relative to fixed income, where relative valuations continue to offer a substantial premium based on historical trends, and stocks are the only asset class that generates positive real returns and tends to perform well in a higher-inflation environment, whereas for fixed income, we recommend a conservative approach in terms of duration.

– Is an aggressive Fed a problem for the stock markets?One transmission channel through which a more aggressive Fed could hurt stocks is via a rise in real rates, since higher real yields reduce the relative valuation advantage of stocks over 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 basis points. This level of real yields implies an equity risk premium of around 5.3% currently for the S&P 500. During the previous corrections in 2015 and 2018, the equity risk premium bottomed out at 4.5%. Therefore, mechanically speaking, we would need to see the 10-year real yield rise by 80 basis points from current levels for equity risk premiums to fall to 4.5%.

– Finally, while the dollar continues to rise to a new high for the year due to growth concerns and a more hawkish Fed, we believe these growth concerns are exaggerated and that the Fed will not be alone in responding to inflation and shifting to a more hawkish 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 interest rates and the euro.

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

Humberto Mora

Strategy and Investments