- We do not expect a 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 an inflection in the Delta variant. While Covid continues to decline, the 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 will likely be countered soon with a policy turnaround.

- Although growth is slowing and inflation is rising, we do not foresee a "stagflation" scenario, as demand remains strong and financial conditions lax.

- In our base case we will continue to have higher inflation, but also higher growth and this has important market implications. A stagflationary portfolio should be OW in commodities, neutral in stocks and UW in bonds. In contrast, a more inflationary portfolio should be OW in commodities and stocks and UW in bonds more aggressively.

- Against this backdrop, risk assets would continue to do well and bond yields appear to be finding a floor, which generally bodes well for cyclical value leadership.

- We see a lot of emphasis on high equity valuations, but little talk of the unattractiveness of prime rates and corporate spreads with little room to compress. 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 to overweight equities over fixed income, where relative valuations continue to offer ample reward for their history and equities are the only asset class that produces positive real returns and tend to perform well in a higher inflation regime, while for fixed income we recommend a conservative approach in terms of duration.

- Is a hawkish Fed a problem for equity marketsOnetransmission channel through which a more hawkish Fed could hurt stocks is through a rise in real rates, as higher real yields reduce the relative valuation advantage of stocks versus bonds. However, we continue to have difficulty characterizing stocks as expensive when real yields remain so negative, with the 10-year real UST at -88 bps. This level of real yields implies an equity risk premium of around 5.3% currently for the S&P 500. In the prior correction of 2015 and 2018, the equity risk premium bottomed at 4.5%. So, mechanically, we would need to see the 10-year real yield rise 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 on growth fears and a more hawkish Fed, we believe these growth fears are overblown and that the Fed will not be alone in responding to inflation and the shift to a more hawkish stance . In fact, over the more medium term, we see a risk that the ECB will follow the Fed's shift putting upward pressure on both European rates and the euro.

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

Humberto Mora

Strategy and Investments