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1. Time to fade European equities

European equity indices have screened as rich to aggregate macro conditions for a few weeks now. But now there are two new developments:

• Fair Value Gaps have extended well over 1 sigma rich. SX5E is 1.5 sigma (3.1%) above fair value
• Qi model confidence is rolling over

The fall in model confidence suggests macro cannot explain the last part of this rally. That could refer to excessive positioning/sentiment, or perhaps greater political influence ahead of Germany's election on Sunday.

Either way, at least from a tactical macro perspective, the risk-reward around the strong start to 2025 for European equities has shifted lower

2. Time to fade 10y BUND yields

The flip side of the recent rally in European stocks is a back-up in Bund yields; nominal yields have risen over 10bp this week, while real yields are at 2025 highs.

The assault is coming from both monetary (hawkish ECB speak dialling back rate cut expectations) and fiscal (greater bond issuance to meet future defence commitments) policy.

That combination has taken spot yields 1.1 sigma (16.5bp) above Qi model value. Model confidence is low but there are two additional warning flags.

• Qi's tactical Short Term model has exactly the same Fair Value Gap - yields sit 1.1 sigma & 14bp above aggregate macro conditions.

• The correlation between the Long Term model's FVG and spot 10y yields is high. The suggestion being the gap closes by yields catching up/down to prevailing macro conditions.

3. KWEB also vulnerable

The European equity example above suggests there's potential for the early 2025 momentum trade that favoured the RoW, to flip to a mean reversion strategy back towards US exceptionalism. The same holds for Chinese tech that's enjoyed a great run since DeepSeek.

On Qi, KraneShares China Internet ETF KWEB now sits 1.6 sigma (12.6%) rich relative to the NASDAQ ETF QQQ.

There's a health warning - Qi model confidence is low (17%) but the counter to that is there's very strong (85%) correlation between the spot RV pair & Qi's FVG. A sign that overshoots have tended to correct via spot prices mean reverting back to model fair value.

Introduction

Qi’s Macro Equity Factor Risk Model (MFERM) provides a daily macro factor risk forecast for an equity security or portfolio. This forecast is a function of the security’s macro factor exposures and an exponentially-weighted covariance matrix of the macro factors themselves.

Our basic hypothesis is that Mr. Market is a neurotic patient that would prefer a backdrop of factor stability over rising volatility. By way of example, equities want tighter credit spreads, but if the sensitivity to credit spreads is increasing as opposed to stable, market attention is clearly more focused on the health of the credit cycle.

When Qi’s factor risk forecast spikes, we should reduce risk. By reducing the impact from the left-tail of the potential distribution of outcomes, we should be able to improve risk-adjusted returns. We ran the below exercise for the S&P500.

Exercise:

• Run Qi’s Risk Model on the S&P500 Index to obtain a daily risk forecast, split between factor and specific. We went back 11 years to 2014. For both total and factor predicted risk we executed the below steps:

• Convert the daily risk forecast into a z-score based on a short lookback period to capture sudden spikes in predicted vol. Without any optimisation, we use a fixed look back of 50 trading days - akin to using a 50d MA to represent the intermediate trend.

• When the risk z-score is greater than or equal to 2.5 sigma at the session close, reduce your 100% long in the index to 50% long in the NEXT session. In other words, you are long 2 lots of S&P500 futures but the following day you go short 1 lot leaving you effectively long 1 lot. Given the short lookback window for the z-score, we wanted to identify meaningful risks deep in the tail to signify outliers to the prevailing regime. No trading costs are assumed, but given we look deep in the tail we assume this will not be highly active strategy.

• When the risk z-score falls below the 2.5 sigma threshold at the session close, go back to 100% long i.e. fully invested in the NEXT session.

Finally, we tested a further variation:

• When the risk z-score is greater than or equal to 2.5 sigma at the session close, reduce your 100% long in the index to 50% short the NEXT session. In other words, if you are long 2 lots of S&P500 futures, the following day you go short 3 lots leaving you short 1 lot.

Results

Applying Qi predicted total risk:

• Since 2014, there have been 24 events where our MFERM Risk Z-Score has been greater than or equal to 2.5 sigma.

• 67% of those events saw our intervention yield better results than staying fully invested. In other words, 16 out of 24 times, the market was lower during our adjustment period.

• Of those 16 winning events, the average unannualized outperformance was 1.50%. Of the 9 losing events, the average unannualized underperformance was 0.61%. In other words, the size of win to loss ratio is 2.5x.

• The impact of this is to lift the information ratio (average annualised return / annualised vol) of the S&P500 from 0.8 to 1.0.

• On a calendar year basis, the adjusted portfolio delivered an annual outperformance of 1.8%, outperforming in 8 out of the 11 years from 2014 to 2024.

• The top 3 calendar year improvements were seen in order – 2020, 2022 and 2018 – years associated with higher volatility. 2014 was really the nadir of the "sell the vol" mantra post the GFC.

Applying Qi predicted factor risk:

• Reducing risk when the MFERM factor risk z-score rose above 2.5 sigma also lifts the information ratio from 0.8 to 1.0, confirming that factor risk is indeed the dominant feature of total risk for the S&P 500. Annualised returns and vol are almost identical over the period.

• Importantly, max drawdowns also improved significantly using both approaches.

• A final sense check: If instead of reducing risk to 50% long we went 150% long when we hit our trigger events, the information ratio drops from 0.8 to 0.6. This confirms that our intuition to minimise the impact of factor vol shocks was correct. Factor risk spikes are a headwind not tailwind.

What if we went net 50% short on a trigger event?

• Going 50% net short on our trigger events, lifts the information ratio further from 0.8 to 1.2 whether we used predicted total risk or factor risk

Charts & Tables

Full analysis available on request.

Conclusion:

The simplicity of this approach is appealing - Take risk mitigating action when MFERM predicted vol spikes. Many funds will run more sophisticated optimisation processes. However, integrating Qi’s forecasts also into decision making has the potential to provide an edge for risk-adjusted returns.

1. Time to fade long duration stocks

Long duration stocks are nearly 2 standard deviations rich relative to Short Duration stocks on Qi's model.

Even without our usual 65% R-Squared constraint, this is a rare event - it’s only been this extended 4x in the last 15 years.

Strong correlation between Qi's FVG & the spot price of this basket pair suggests the mean reversion has recently occurred by the market correcting back towards macro fundamentals.

Recently, the market narrative had shifted to the downside risks to economic growth from DOGE cost cutting & tariffs. Yesterday's CPI reminded us that inflation volatility is not going away. On Qi's metrics this is a good time to fade long duration equity plays.

2. Low Vol is not a good hiding place

In this recent market chop, low volatility strategies have done well, and yesterday's CPI beat will encourage some to move further into defensive strategies.

Note, however, that on Qi, USMV now sits 1.1 sigma rich relative to the broader market. That's the rich end of the FVG range over the last few years.

Qi's model value has stopped falling but is not consistent with this rally. That leaves the RV pair as 2.9% rich to model. The risk-reward does not favour this as the best defensive refuge right now.

3. Inflation hawks in the ascendancy

Yesterday's CPI added extra momentum to the recent re-pricing of US inflation expectations & lend weight to the higher-for-longer scenario for Fed policy. The one solace might be that a fair degree of the bad inflation news is already priced.

One of the market's favourite gauges is 5y5y forward inflation which the Fed are believed to closely monitor. Qi's macro-warranted model value sits for 5y5y sits at 2.48%. The market currently sits around 10bp above that.

Qi's FVG has done a decent job of capturing turning points over the last year plus. Model confidence of 49% precludes an official bearish signal but the suggestion is the sticky inflation scenario is, to a fair degree, already discounted.

Details

1. Qi’s Risk Model - Today, Value vs. Growth Have Divergent Needs:

The revelation from Qi's Risk Model is that Value and Growth have distinct and divergent needs. In turn, this has ramifications for the hope of higher market breadth i.e. SPW vs. SPX and 493 vs. Mag 7:

Value wants a Goldilocks environment: A weaker dollar, lower real rates, and higher nominal GDP growth.

Growth has no issue with tighter FCIs: It wants a stronger dollar, higher real rates, and lower nominal GDP growth. As we confirm below, the hypothesis is that this is driven by a thematic bet on the secular AI narrative, which counterbalances the traditional macro risks like tighter FCIs / lower growth.

This is a break from past norms: Over the last decade, higher real rates implied higher economic confidence allowing respite for Value; while tighter FCIs hurt Growth by raising the cost of capital. Today, those reaction functions are different.

Further, the size of these differences are stark relative to recent history: The negative sensitivity of Value / Growth to real rates is at 5yr lows; the positive sensitivity to economic growth is close to 5yr highs:

2. Digging deeper - MegaCap Tech is the source of Growth’s positive real rates sensitivity

Both the average market cap and forward earnings growth for growth stocks with a positive real rates sensitivity is ~80% higher compared to those with a negative sensitivity. As you can see below, MegaCap Tech’s defensive qualities is not representative of the entire Growth universe.

3. Why this matters?

Real rates remain a key risk: The bottom line is that the broader market, outside of the mega cap Growth stocks, still remains highly sensitive to real rates and a Goldilocks outcome.
To empirically make this point, below we show the same chart of the 3 rotations but vs. 10yr real yields (inverted) and vs. the Atlanta Fed GDP Nowcast.

Details

First, for context, 5 recent facts sowing seeds of uncertainty:

• Earnings Disappointments : 6 of the Mag 7 have reported Q4 results so far and 5 out of those 6 have disappointed expectations. This cohort of stocks accounted for ~75% of S&P500 earnings growth last year. KWEB is +10.8% ytd vs. Nasdaq 100 +2.3%.

• Tariff Risks : The size of tariffs announced on Canada, Mexico and China are multiples higher than the size of tariffs imposed on Chinese goods in 2018. The initial fear of a US / China trade war then saw the S&P500 swiftly correct 9% from its local high in March 2018. Today, the S&P500 is 1.5% off ATHs.

• Recent Data : The JPM composite global PMI survey fell in January – for the first time in four months. Feb Michigan consumer confidence also fell to 7mth lows, with inflation fears cited.

• Policy Uncertainty : The global economic policy uncertainty index (which scans country newspaper coverage) is now at its highest level since the height of COVID. Not seen even in Trump 1.0.

• German Politics : A new poll in Germany suggests it may be more difficult to form a coalition government in Germany without the Greens. The DAX is one the best performing stock markets this year despite the fact that German exports to the US have expanded massively over the last 4yrs.

In light of the above, 3 take-aways from Qi’s Risk Model which indicate that the risks are underpriced:

• Factor Return Disconnect : Since the US election, S&P500 returns have been well explained by macro – the attributable share of returns from macro factors has been high. However, in recent weeks we have observed a disconnect between S&P500 spot returns and the attributable factor return. The move higher in recent weeks is not being supported by the macro backdrop. This, of course can reflect idiosyncratic drivers. However, given the above stated facts this divergence is unnerving.

• Factor Vol Impulse More Likely to Rise than Fall : Mr. Market is a neurotic patient that would prefer a backdrop of macro factor stability over rising volatility. Predicted factor volatility is derived from the S&P500’s factor exposures (as per Qi’s MFERM) together with a factor covariance matrix. The below chart shows the 1mth rate of change in our measure of macro vol to give hints about the state of the market mindset. Falling and low = greed; Rising and high = fear. Today, this measure is at the low end of its historical range. Recent history shows it can of course remain in a low range e.g. 2023. But, 2025 faces elevated valuations and a distribution of outcomes that is still very wide.

• High correlation to Idiosyncratic Drivers can portend macro complacency : Qi’s Risk Model breaks down S&P 500 returns into macro and idiosyncratic factors. When we track the correlation between actual returns and these factors, we gain insight into the market’s macro sensitivity.

• Below, we show the 3mth rolling correlation of the daily S&P 500 return to the daily return attributable to idiosyncratic factors i.e. factors which can not be explained by macro. That correlation is right at the ceiling of the last 2yrs. This was a precursor for a risk pull back / rise in volatility in the Summer of 2023, Spring of 2024 and December 2024.

• Why does this matter? High correlation to idiosyncratic factors signals potential macro complacency. When the market relies too much on non-macro drivers risk builds up and previously we have seen the tension snap.

1. A message from bonds & commodities

Much of 2025's early price action seems consistent with the idea we're sitting in the middle of the Dollar smile - a point where economic growth is just decent enough to undermine US exceptionalism & favours the RoW.

There are two warnings from the commodity & bond market that could disrupt the idea we're in that middle sweet spot.

Firstly, the red warning - Qi's model of the Copper / Gold ratio is falling to levels only previously seen during Covid lockdowns & the GFC.

The ratio of industrial versus precious metals is an old school gauge of the global economic cycle - new lows suggest the commodity market is growing more fearful of a global trade war & hence recession.

Secondly, the amber warning. Since mid-December, UST yields have been too high relative to prevailing macro conditions. Now 10y US Treasury yields are back at 4.45%, Qi's macro-warranted model value.

Qi's model is strong (84% confidence) & the market has now mean reverted to macro fundamentals. Going forward, watching Qi model value for clues on macro momentum is critical.

It has fallen 12.5bp since mid-January: rising inflation expectations have been offset by a moderation in economic growth, a pause in the hawkish re-pricing of Fed rate cuts plus more subdued rate volatility. Qi provides a real-time aggregation of these crosswinds.

Bessent has flagged how important 10y UST yields are. That's especially true now since a deflationary signal from both the bond and commodity market together would threaten a host of trades that have been the early 2025 performers.

2. European Banks - too far, too fast

Perhaps a surprising fact is that European banks have outperformed the Magnificent 7 over the last 1yr. Sector performance has particularly accelerated since last November.

The macro drivers reflect the sector’s reflationary posture. It wants higher GDP growth, a stronger Euro, higher metals, higher real yields and tighter credit spreads.

However, through this year the valuation gap between spot price and Qi’s macro-warranted fair value has expanded to +1.1 sigma. The fair value gap is at its highs relative to the last 1yr. See the chart below where we plot the sector’s fair value gap against its spot price – the strong relationship is sending a warning Qi’s FVG for the sector is an exploitable mean-reversion opportunity.

To empirically see this disconnect, below we simply plot SX7P vs. copper and real yields.

Idiosyncratic drivers may well have dominated – earnings have been solid and investors have been looking for value in the face of concentrated US market. However, Trump has made clear that he will “absolutely” impose tariffs on the EU. Needless to say, any worsening of credit owing to economic impacts from trade war escalation will have an oversized impact on banks.

Thus far, European markets have been exceptionally resilient. There is hope for lack of trade escalation but “hope” is a not a strategy. We are simply highlight that tariff risks are not being fully priced in.

3. Value the Comeback Kid but tariff risks temper the enthusiasm

In line with the observation above on European banks, Value has been outperforming Growth since late last year. This is a reflection of the challenge to the US Exceptionalism thesis. The outperformance we have seen has come alongside the weakness we have seen in the Dollar YtD. See the chart below highlighting the strong inverse relationship of late.

Growth, and its close cousin Momentum, is the style more synonymous with the Trump boom trade of higher economic growth, higher rates and stronger dollar. Indeed, its outperformance over Value has come alongside the US equities outperforming RoW World equities.

Now delaying implementation leaving scope for negotiations has seen the dollar move lower after the initial Executive Order was announced. However, we do recall that when tariffs eventually materialised in summer 2018, the news did lift the dollar. For now, the lingering tariff threat could limit Dollar downside.

Below we should the relative performance of Vanguard Value vs. Vanguard Growth overlaid with Qi’s fair value gap of the pair. The latter is close to the highs of it 1yr range. While, we share the view that US Exceptionalism is at risk (see last week’s note), it won’t be so straightforward if trade wars escalate.

4. Similarly, DAX outperformance at risk

Perhaps another surprising fact, the DAX posted in Jan its best monthly performance since November 2023! Economic growth is the largest broad macro driver of the index. See the chart below. Thus far, global growth expectations have been rising whether we see the Citi global economic surprise index or the Eurozone and Japan composite PMIs moving above 50. Alongside, there is an expectation that the results of the forthcoming German elections act as a catalyst to release the debt brake and pursue a more expansionary fiscal policy.

However, earnings expectations have been relatively stagnant over the last year in comparison to price performance i.e. we have seen significant PE expansion. See the chart below.

Further, within Europe we know that the beta to global trade is highest in Germany. The likes of Autos and cyclical sectors would be the most vulnerable on higher trade uncertainty.

Qi shows that the DAX would benefit from a weaker EUR reflecting its global exposure. Our concern is that the flipside is the EUR can act a risk-on / risk-off barometer. As we showed in last week’s note, a strong dollar has tended to mean under-performance of non-US markets historically.

What it striking to us is the Qi fair value gap for the S&P 500 relative to the DAX has hit 1yr lows. Therefore, tactically, this is not an area where we want to push the “US exceptionalism at risk” narrative. See the chart below.

5. USD downside

At the start of the week, USDCHF screened as 1 sigma (2.5%) rich to macro conditions. A historically significant level with back-tests revealing it has a 76% hit rate as a bearish signal.

That Fair Value Gap has subsequently narrowed but the cross still sits 1.6% above macro-warranted fair value.

Both the Dollar & Swiss Franc are considered flight-to-quality beneficiaries, but Qi’s model (which has 75% explanatory power) suggests the Franc remains the ultimate safe haven. Current patterns show higher VIX is consistent with lower USDCHF.

The upshot is twofold. Firstly, the negative relationship with risk aversion means - at these levels - it’s increasingly tough to justify USDCHF upside based exclusively on a "risk off" mood in markets.

Secondly, at the broader macro level the risk-reward is skewed to USDCHF downside. That's regardless of whether VIX is above or below 20; and especially true with regard to Bessent & 10y US yields given that interest rate differentials screen as the dominant driver of the cross right now.

Details

Over the last year, European Banks (SX7P) have outperformed the Magnificent 7:

Through the last year, the following factor exposures dominate:

• V2X & Itraxx Xover as proxies of risk sentiment

• Copper & EU GDP Nowcast as proxies of growth expectations, albeit less so than earlier in 2024

• EUR TWI and real yields as proxies of Eurozone confidence, which have risen in importance through the year
A few of these factor sensitivity exposures over time are highlighted below:

Indeed today, the ranked exposures also reflect the above – a clear desire for a reflationary regime:

The importance of macro for the SX7P’s returns was rising through the majority of 2024.

BUT that importance relative to idiosyncratic drivers peaked at start of November.

This is illustrated below by a 3mth rolling RSq of the daily spot returns of the index vs. the daily attributable factor return as determined by Qi’s Risk Model.

What is striking, is that this decline in macro importance is at the lows of the last 3yrs – just as fears of trade wars have accelerated on this weekend’s news.

With respect to returns, this breakdown in recent correlation is reflected in the below return attribution chart – we show SX7P’s cumulative return since 2022 alongside the factor return. Recall, we show the factor return on the rhs axis – unlike stocks, macro factors do not trend with equity vol like returns and exposures are dynamic over time with some factors propellers and others drags. This has the impact of muting the size of factor returns over long periods. The size of the factor return will in part depend on how aggressively the factors themselves are moving. That said, it is clear that we observe a recent disconnect:

To empirically see this disconnect, below we simply plot SX7P vs. copper and real yields.

1. US Exceptionalism at risk = Momentum at risk relative to Value = Risk to Dollar

Earlier this week we wrote a note questioning if US exceptionalism was now at risk. Technically, the US bull market started in 2023 following the >20% correction in 2022. Incidentally, soon after the release of ChatGPT in Nov22. History may not repeat but the third year of a bull market is associated with single digit returns. Couple this with an equity risk premium at 20yr lows, Trump policy execution uncertainty and now it seems question marks on what multiples to pay for Tech given the DeekSeek news.

If we are in a single digit US equity return world, RoW has room to outperform. Consider that when the US is up 20% no one cares about RoW. When the US is down 20%, you sell everything. So, in a single digit return world, do we have room for RoW?

With this in mind, we note that the relative performance of the S&P500 vs. MSCI World ex US is synonymous with the relative performance of Momentum vs. Value. See the first chart below.

Delving further, Qi’s models shows that Momentum is a bet on higher real rates, higher dollar, higher economic growth – it is the style synonymous with the Trump boom trade. See the following 2 chart charts below highlighting these relationships. The dollar will play a clear role in determining if US exceptionalism is indeed at risk.

2. COPX – efficient cyclical long

Reversal or rotation? Does DeepSeek blow up a richly valued tech sector &, by extension, threaten the broader US equity market? Or is this a micro story - it hurts Nvidia, but cheaper access helps plenty of end users of generative AI & therefore the broader economy?

For those who believe in rotation, the copper miners ETF COPX now sits 11.7% cheap to our model. Overall macro conditions are moving sideways within a broad range.

The miners were hit hard this week as President Trump threatened to include copper, aluminium & steel amongst the areas where he would impose tariffs.

There is no escaping the volatility a Trump presidency brings. Policy announcements will come thick-&-fast via social media posts. Markets will gap up & down accordingly.

The only thing investors can do is stick to a framework where they identify what they like over the medium to long term. And then await a headline to provide an attractive entry level. We may have that now with COPX.

3. Government bonds – where next?

The question of whether the DeepSeek story is a macro or micro shock is critical for bond investors. Monday’s equity sell-off prompted a sharp safe-haven driven rally in govvies. Is that justified?

Qi’s models for government bonds includes economic fundamentals (the growth / inflation outlook) plus measures of risk appetite. That provides an instant ready reckoner of where markets are priced relative to both dynamics.

Right now:

• the most effective trade for bond bears looking to fade this week’s move is in 2y USTs where yields sit 0.3 sigma (12bp) below macro fair value.

• hard “risk off” proponents should look at 10y Bunds where yields sit 0.9sigma (15bp) too high to aggregate macro conditions.

• a risk off “lite” scenario favours 10y OATs & BTPs. For yield hungry investors, the FVG for both 10y French & Italian bonds looks similar to Bunds – almost 1 sigma too high.

4. European Bulls should favour Tech over Luxury

Since the US election, the best performing sector in Europe is SXQP – personal & household goods – dominated by luxury goods. Banks and Technology have also outperformed but the relative winner has been European luxury goods. However, the most recent results of LVMH saw overall Q4 revenues only rise 1% y/y. Sales in the region that included China fell 10% y/y. While recurring operating income missed estimates. The result is that the stellar performance of the sector relative 12mth fwd earnings expectation is likely now questioned.

The same disconnect between price and earnings is not seen for technology names. We posed the question in our note earlier in the week if Trump is actually a catalyst for RoW to act more forcefully on investment in AI to maintain competitiveness, particularly in light of the Stargate initiative.

Scanning Qi’s models, we see a large disconnect open up in the macro warranted valuations of SXQP relative to SX8P (Technology sector). The valuation gap of SXQP vs. SX8P is at +1.9 sigma. The mean-reverting relationship of the FVG to the price relative has remained intact over the year, implying that European bulls here should favour Tech over Luxury.

5. XLK vs. SPY - tactically oversold

Any focus on Technology stocks inevitably requires a focus on the US outlook. On Qi, screening US sectors versus the broader market, the cheapest RV pair currently is XLK vs. SPY.

It sits 1.5 sigma (3.7%) cheap. Qi model value has been flatlining in January, so the DeepSeek sell-off looks like it has overshot somewhat relative to macro fundamentals. Decent corelation between the RV pair & Qi's FVG suggests there's scope for a profitable mean reversion.

6. GBP - worst G7 currency in 2025

The mood music in the UK remains downbeat - the post Budget fallout for jobs & growth continues to weigh despite the government's attempts to talk a positive game. The latest bearish narrative comes from the weak Pound (the worst performing major currency year-to-date) & its potential to make imported inflation worse & limit the BoE's ability to cut rates.

On Qi, Sterling screens as cheap versus its peers. Cable especially which sits over 1 standard deviation below model fair value.
Over q4 last year Qi model value for Cable fell 4.7% but macro momentum is turning. Model value bottomed on Jan 15th & has bounced 3% since then. In short, there's a fair amount of bad news already priced in & macro conditions are showing signs of improving.

High conviction bears determined to overrule a quantitative framework should look at GBPAUD rather than Cable. Aussie is another unloved currency in 2025 – proximity to China & RBA rate cuts tend to dominate qualitative commentary.

On our metrics GBPAUD is the one G7 cross where Sterling screens as rich. The FGV is +0.74 (+1.2%). The chart below overlays spot with the Qi FVG - it shows the Valuation Gap can extend further, but a strong correlation suggesting its done a decent job of capturing local highs & lows.

First, a series of facts to provide context:

• Foreigners own a historical record amount of US equities: ~30% of total equity market cap.

• FXI, the Chinese large cap ETF returned 29% in 2024, outperforming SPY for the first time in 7yrs. China is investable despite what commentators say.

• Technically, the US bull market started in 2023 following the >20% correction in 2022. Incidentally, soon after the release of ChatGPT in Nov22. History may not repeat but the third year of a bull market is associated with single digit returns.

• The S&P500 equity risk premium is at 20yr lows (proxied by the index earnings yield relative to 10yr risk free).

• The current Republican majority in Congress is one of the slimmest in history.

• Scott Bessent has an objective to boost US GDP growth to 3% while at the same time reduce the budget deficit from 6% to 3%. The Atlanta Fed GDP nowcast is already today at ~3%.

• The Eurozone and Japan composite PMIs are now >50.

• DeepSeek, the Chinese developed LLM, has achieved competitive results with significantly fewer resources than

Given the above, a series of observations and conjectures:

• US equities are priced for perfection, the RoW is not – The S&P500 has outperformed MSCI World ex US by >400% since the GFC.

• If we are in a single digit US equity return world, RoW has room to outperform. Consider that when the US is up 20% no one cares about RoW. When the US is down 20%, you sell everything. So in a single digit return world, do we have room for RoW?

• Is Trump actually a catalyst for RoW to act more forcefully on fiscal policy? Will the German elections unlock the debt brake? China has substantial room to act fiscally. Japan is world’s largest holder of treasuries after China. There is risk of further repatriation to drive their domestic agenda.

• Is peace in Ukraine bearish Europe or actually bullish?

• Successful execution of Bessent’s 3 arrows is a tough ask given the slim majority and deficit target.

• Are we at peak Trump vibes with the launch and subsequent sell off of Trump / Melania coin?

• DeepSeek’s innovation questions the return on the huge AI capex of the US Tech MegaCaps. It is willing to share its breakthroughs and therefore a potential disruptor to US AI.

• US equities may well do fine in 2025 but if US exceptionalism is questioned RoW will outperform…in the words of Wayne Gretsky, skate to where the puck is going.

So what to look for? To be right on the above, the dollar must weaken and commodities rally.

What does Qi’s macro factor equity risk model show? The attributable factor return of EEM and EFA (ie. the return trajectory based purely on macro drivers) have been rising YTD relative to SPY. Why? The top driver is the 7% rally in copper YTD. The weaker dollar, stronger economic growth and higher WTI have also allowed for relative factor return strength. See the series of charts below.

1. Climbing the wall of worry but SPY FVG narrowing into earnings season

Last week, we said that AAII sentiment and the SPY Qi FVG had hit 1yr lows. So far, post the inauguration, risky assets have given a vote of confidence and climbing that wall of worry. Trump’s comments on tariffs are still being seen through the lens of a negotiation tool – more bark than bite. The start of earnings season has also been supportive, critical given Qi’s short term model highlighting that FCIs are front and center. This has meant fair value gaps have narrowed – on both Qi’s short term and long term models we are approaching model fair value.

In December last year, Qi’s short term horizon model for SPY saw macro explanatory power slump to almost zero! Since the turn of the year, it has shot back up to 79% RSq today. No surprise that the top drivers of SPY are real rates, HY corporate credit spreads, CB QT expectations (rate vol) and oil prices. Having been immune to tighter FCIs over the last couple of months, the negative relationship is now resuming. In other words, with profit multiples likely remain constrained by FCIs for now and FVGs closing, this earnings season must shine. Next week is when we start entering the heart of the season.

2. Within commodity plays, XLB better bet than XLE

The best performing sector YTD is Energy. Trump repeated the slogan “Drill, baby, Drill” in his inauguration speech. The reality is that after record crude production under Biden it may be harder to deliver on all the big talk with prices also under pressure from faltering global demand. The sector screen now as the richest relative to its sector peers at +0.8 sigma.

However, where XLE looks most extended is relative to Materials. Above we show the Qi fair value gap of the XLB vs. XLE pair (in blue) and the spot price in white. The FVG sits at 1yr lows. If you believe the market is too bearish on US / China relations and tariff posturing is a prelude to a better deal, this would be bullish the pair.

Our backtest of long signals when reaching -1 sigma FVG, reveals an 64.5% win rate with a positive average return.

3. Beware US yield curve flattening

Curve steepeners are a consensus trade amongst rate investors. There are strong arguments for that idea but tactically there is potential for the yield curve to flatten in the near term.

On Qi, macro-warranted fair value for the 5s30s US yield curve is -23bp. Fair value was -14bp at the start of 2025. The additional inversion has been driven by the surge in tracking GDP growth & increase in inflation expectations (inverted in yellow below).

On current patterns, higher-for-longer from the Fed should equate to a flatter yield curve. The market has lagged that re-pricing with 5s30s USD swaps curve currently sitting around -11bp.

4. How to trade "Stargate"

President Trump's announcement of a joint venture between the US government and tech leaders like Softbank, OpenAI & Oracle is a potentially huge, game-changing event. But how are investors supposed to capture this trend?

Thematic baskets from the sell-side offer you the stock picking skills from their sector analysts, plus the diversification of an ETF.

One obvious example would be Goldman's Power Up America - a basket of stocks designed to "benefit from the growing demand for power driven by electrification, EVs, data centres & reshoring".

On Qi, there's no valuation edge currently. It was 1 sigma (10.5%) cheap to macro conditions at the end of last year, but has now caught back up. From here it's a case of watching macro momentum (i.e. Qi model value) which is trending firmly higher.

GS's AI Beneficiaries vs at risk basket hit 1 sigma cheap as recently as last week. This week's Trump bump has seen the Valuation Gap half but it still sits 0.5 sigma (2.7%) below Qi's macro-warranted model value.

Moreover, that's still a significant level - this FVG has only been seen 5x when the model is in regime & has produced an 80% hit rate. FVG correlation to spot price looks decent of late, i.e. we can trust the mean reversion properties of this signal.

Further afield could something like Goldman’s Japan Semiconductors basket benefit from such a theme? It sits 0.7 sigma (9.4%) cheap to the broad macro environment. Qi model value has moved up this week but is yet to break above the 4month range. Watch macro momentum for clear signs of a new uptrend.

5. RoW > US equities?

Headline risk is going to be a constant threat under Trump 2.0. Today's Davos address, for example, could spark a "risk off" move if he sounds hawkish on trade. But, thus far, the lack of detail on tariffs has prompted a sigh of relief. That's most evident in FX with volatility falling back from elevated levels.

In equities its most obvious in the rally in European indices. The question facing asset allocators is , if they believe RoW stocks can enjoy a period of catch-up to the US, which international markets offer the best risk-reward? This is where Qi model value & Fair Value Gap can be invaluable. Some examples:

The DAX sits 0.7 sigma (2.7%) rich to macro. But note the strength of macro momentum. Qi model value has risen 3.6% in the last two weeks alone. The market is moving further & faster implying this isn’t a great entry level. But there's no definitive bear signal here given improving macro conditions.

The Euro Stoxx 50 screens as 1.5 sigma (3.1%) rich to macro. Macro-warranted model value has risen but not to the same degree as the DAX. A richer FVG plus more modest macro momentum suggests pan-European indices look potentially more vulnerable to any trade shock.

But perhaps the most interesting observation is that asset allocators should be looking east to Asia. The TOPIX for example is lagging the early 2025 equity rally. It sits 1 sigma or 3.1% below aggregate macro conditions which again are trending higher.