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1. Renewables – a Cheap Hedge for a Harris Victory

Harris would be expected to continue and expand on Biden’s climate policies, prioritising investments in the renewable energy sector. With this in mind, we note that the performance of ICLN (Global Clean Energy ETF) has closely tracked the RCP Harris betting odds – see the first chart below.

However, Qi’s model for ICLN shows the sector now trading at a 1.7 sigma discount to model value. Model explanatory power has been falling into October because our standard model does not factor in the recent excitement around Trump and his policies. With that said, consider the chart below – this is the largest discount ICLN has been vs. Qi’s model value for some time. Only 3 times since 2009 has it been at this discount. 2 of those 3 occasions were buying opportunities.

2. Back End of Rates now an Open Risk – Winners & Losers

A Republican sweep risks resulting in higher deficits and a pickup in inflation, hitting fixed income even harder than we have seen in recent weeks. Even under a Harris victory, there is almost no prospect of any deficit reduction plan. In other words, the back end of rates now seems like an open risk. Longer term treasury yields broke out of a forty-year downtrend in 2021 and show no sign of returning anytime soon. Bond vol represented by the MOVE index and proxied by CB QT Expectations in our models has ramped higher into October.

The equity market would posit that the backup in bond yields is more of a reflation trade. However, Qi’s model would suggest the move in rates is more about inflation fears than growth hopes.

With this in mind, the first chart below shows sector sensitivities to real rates based on our multi-month relational model alongside the spot vs. model fair value gap. We note that Tech (SOXX, XLK) and Energy (IEZ, XOP, XLE) are not perturbed by higher real rates and are still deemed cheap to Qi model. In contrast, homebuilders / real estate (ITB, XHB, IYR), Retail (XRT), Small Caps (IWM) and gold miners (GDX) would be hurt by further rises in real rates AND are trading rich to Qi model.
The second chart plots those sensitivities to both real rates and rate vol – a similar picture emerges.

3. Higher bond yields globally – does that make sense?

Last week we noted it’s been unusual for US Treasury yields to trade above Qi’s macro-warranted model value in 2024.

At the time, the Fair Value Gap was a modest +0.5 sigma. This week’s 4.33% yield high equated to a +0.9 sigma FVG. Close, but not quite sufficient to trigger an official bullish signal on Qi. What is equally striking is the fact that this has been a global move.

The magnitude of recent yield moves differ across countries, but the bearish repricing has been universal. Yet the consensus is that the European growth outlook for example is significantly more challenged than in the US.

So, should dip buyers in bonds focus on opportunities away from US Treasuries?

The chart uses the Macrobond platform to show Qi Fair Value Gaps across 10y yields in several different countries, plus the 1y historical percentiles of those FVGs.

The standout are 10y gilt yields which are now 1.8 sigma (25bp) above Qi model value. That’s an extreme relative to recent history & clearly reflects market fears following the UK budget.

Bunds also stand out – now 1.2 sigma (17bp) cheap to macro at a time when most are bearish economic growth and this results season is seeing forward 12mth earnings roll over aggressively.

4. Small Caps Increasingly Vulnerable to a Strong Dollar:

The Dollar has become the biggest negative driver of both Qi’s SPY and IWM models. QQQ has become indifferent. See the snapshot below showing the % change for a 1 standard deviation move higher in the dollar.

While the caveat is all 3 model explanatory powers are rolling over, anyone believing in a rotation out of tech into small caps, needs to know that IWM is increasingly vulnerable to a strong $ (& screens as 0.7 sigma rich).

5. Equal-Weighted Consumer Discretionary (RSPD) – Too Much Good News Priced In?

Among the largest FVGs we see at the sector level is for equal-weighted consumer discretionary (RSPD). This ETF includes the likes of Amazon, Tesla but maintains an equal weight across all holdings (quarterly rebalance). The recent excitement around Trump beneficiaries like Tesla and General Motors (not dependent on China for EV batteries) is understandable, but this equal-weighted version tries to adjust for that.

According to Qi’s model, RSPD wants stronger global GDP growth (the largest driver in aggregate), a steeper 5s30s curve (would prefer to see short term rate cuts), a weaker dollar and lower real rates. See the snapshot below.

However, the last month has seen Qi model value flat-line, leaving the FVG extended at +1.3 sigma.

1. If FCIs have seen their floor ITB is at risk of rolling over. Over the last 1yr, the ITB Home Construction ETF has delivered a 61% return – among the best across all US industry groups.

2. Macro matters for ITB – There is 62% correlation (39% RSq) between daily ITB returns and macro factor driven daily returns over the last year.

3. Over the last week, the drag from macro factors has been particularly large. Qi’s MFERM model dissects the return of ITB into its macro factor & idiosyncratic / specific return components. Note the recent divergence between the spot return and factor return in the chart below.

4. Where does this recent factor drag stem from? FCIs. USD TWI, forward growth expectations (5s30s), rates, HY corporate credit and CB QT expectations have all been drags for ITB over the last week.

5. From propellers to drags: Indeed, for rates, 5s30s and USD TWI the factor returns have switched from propellers to drags over the last 1mth

6. So what is ITB most exposed to today? HY Credit, the dollar, real rates and it would prefer bull curve steepening.

7. Across industry groups ITB is among the most sensitive to real rates, DM FX and corporate credit: Notable, as wait for inflation numbers this week - a beat would be troublesome.

By the end of last week, the S&P500 had rallied 6 of the last 7 week and sitting 4% above its 50d MA - the world’s most important central bank is easing, and the world’s most important government is stimulating! No surprise therefore to see this rally coincide with a sharp decline in the S&P500 macro beta impulse i.e. falling macro sensitivities. Recall, our hypothesis is that Mr. Market is a neurotic patient that would prefer a backdrop of macro factor stability / low beta to macro over a backdrop of increasing macro factor volatility / high beta to macro. Therefore, when macro betas are low it is a reflection of low fear on macro. The S&P macro beta impulse has hit the low end of its range post Covid. See the chart above.

In similar vein, we show the S&P500 Qi sensitivity to the average of VIX and HY credit spreads (ST model) as a fear gauge proxy. We are clearly in period of lower macro fear, relative to the last few years.

Consider also that SPY model price momentum has been fading over the last month. HY credit spreads are little changed while inflation expectations have been rising.

Looking ahead, if the market is increasingly comfortable on the data, we need to look to inflation expectations. This would have an upward impetus on a Trump surge, China stimulus and falling jobless claims.

While SPY’s sensitivity to High Yield spreads is towards the low end of the ranges, it remains a critical factor. Credit spreads account for 22% of model explanatory power so equity investors need to be aware of some early warning signs that credit is looking extended from a macro perspective.

LQDH is the ETF that provides exposure to US Investment Grade credit with the duration element hedged away, i.e. it is a “purer” credit play. A bearish divergence pattern is developing with the recent rally occurring despite macro conditions starting to deteriorate. If Qi model value falls below the early September low of 91.73, we would start to worry macro momentum is potentially turning.

The same bearish divergence formation is evident elsewhere too. Still in the US, the ANGL ETF captures firms that were rated investment grade at the point of issuance, but have since been downgraded to High Yield. It sits 1.4 sigma rich to macro with Qi model value approaching the September lows.

EMHY (JP Morgan’s EM High Yield ETF) and EMB (hard currency EM sovereign bonds) are over 1 sigma rich in FVG terms with model value rolling over.

The local currency Emerging Market bond ETF LEMB is also rich but there at least macro momentum is still trending higher. Ideally, a retracement would offer a better entry level, but soft currency EM bonds look the best bet to global asset allocators on our models.

Qi is firing warning signals on several China related plays. AIA (iShares Asia 50; 40% China weighting), AAXJ (iShares All Country Asia ex Japan; 29% China weighting) and VWO (Vanguard FTSE Emerging Markets; 23% China weighting) are all over 1 sigma rich to macro-warranted model value.

Copper is now 1.6 sigma rich to macro. LUXU (the Amundi Luxury ETF with Hermes, CIE Richemont and LVMH Moet Hennessy Louis Vuitton as the top 3 holdings) is 1.5 sigma above model value.

Yes there’s a large element of a positioning squeeze driving current price action. But, from a macro perspective, the tradeable bounce has already happened to a fair degree. The risk-reward suggests these are not great levels to chase.

Betting odds show that the Trump/Harris gap is narrowing at 50% probability for a Trump win and 48% for Harris. However, according to Qi, at least at the equity market level, a sudden Trump surge is clearly not priced. If all Trump’s policies were effected, it would be expected to lead to larger inflationary than growth impulse. Yet Qi shows the sensitivity of the S&P500 to Trump betting odds has falling to zero. See the chart below.

In contrast, the sensitivity to 10yr Treasury yields is deemed much higher. Higher Trump betting odds point to higher yields – no surprise given the heightened concerns on a ramp up in the fiscal deficit.

Crude may be close to 3yr lows but other commodities have been holding up better. Copper has risen ~8% from its August lows. Data at the end of last week showed copper inventories on the Shanghai Futures Exchange fall 14% on the week - the largest weekly decline this year – and the LME spot price may have now turned the corner after sinking 20% from a high in May. Today SXPP, the EU Basic Resources sector, is still close to its lowest level since late 2020. See the chart above.

Earlier this week, we note in our MacroHub publication, how depressed sentiment was in Europe (a quarter of the Dax stocks are trading below book value). On Qi’s model, the sector is trading -0.8 sigma (~5%) below Qi model value, hovering close to the 1yr range lows. It is one of the cheapest of the Stoxx sectors in Europe.

Global GDP growth is one of the top macro drivers of the sector. Since July, that sensitivity has accelerated higher firmly into positive territory. If there is belief in a soft landing any sign of a pick up in global growth confidence, owing upside in this space make sense given how depressed sentiment is.

Whatever the extent of the Fed rate cutting cycle, ultimately it is all about soft landing for the economy. The below chart shows the GS Qi long / short basket pair tracking US GDP growth. The dark blue line shows the deviation of that basket from its 200d MA i.e. the deviation from trend as measure of optimism / pessimism. Indeed, shown in this way, there is good relationship with the Citi US economic surprise index. Cyclical re-acceleration may well be a pain trade

Defensives have been among the best performing sectors recently and relative to their sector peers are more expensive on Qi’s macro fair value models.

Tech has been a laggard in the recent SPX rally. Positioning is now also cleaner in the space. Further, we know the strength of Q4 seasonality. SOXX is one of the cheapest sector ETFs at -1.3 sigma. The technology sector in general is a beneficiary of loose financial conditions. See the chart above highlighting the sector ETF sensitivities to FCIs (HY Credit spreads, USD TWI, real rates) vs. sensitivities to GDP. SOXX, COPX, XME, XRT, XLB, IWM, SLF, XLB are all sectors which relatively benefit from loose FCIs alongside trading below.

Above we show the Mag7 12mth fwd PE vs. Qi’s model FVG of the PE. On this basis, the 12mth fwd PE of the Mag7 stands ~1 sigma cheap to model value. That is close to the lower end of the valuation range of the last 1yr. A return to Mag7 leadership into year-end is a possibility if we see re-risking into YE.

Thus far, the recent rotation trade has favoured defensives and certain cyclicals, but not all. Energy has missed out because of the drag from crude oil prices.

But now we note US Energy XLE sits as 0.8 sigma (4.6%) cheap to Consumer Discretionary. Qi’s macro-warranted model value for the RV pair has been flat-lining since mid-August. Put another way, XLE has overshot to the downside relative to broad macro conditions.

Over the last year extremes in Qi’s Fair Value Gap has done a good job of marking local lows and highs in the actual XLE / XLY RV pair trade. If a 50bp rate cut from the Fed helps negate recession fears, maybe its time to be looking for cheap cyclicals that have lagged.

The European 2s10s yield curve was almost 60bp inverted as recently as May. Today it is almost back to flat.

There remain good reasons to think the risk-reward favours further curve steepening over the medium to long term. A hard landing means more rate cuts and a bull steepening; cutting when an economy is slowing but growing risks re-awakening the bond vigilantes who will bear steepen the curve.

But Qi’s model which has a high (72%) and stable R-Squared is suggesting this move may have too-far-too-fast. Relative to aggregate macro conditions, the curve sits 1.6 sigma (21bp) too steep.

The chart below shows there are times when the FVG becomes even more extended - last October around the Fed pivot, the gap reached 3 sigma. Even so we’re getting into thin air. Some consolidation could be healthy and offer better re-entry levels to re-set steepeners.