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Chinese equities have been in the red for 3 consecutive years – unprecedented in modern history. Valuation is never enough – decisive and effective policy delivery is needed alongside an exit from deflation. While China deflation may be welcomed by the world, Qi analysis shows a glaring disconnect between China sentiment and DM risky assets.

Qi screened European and US equities most sensitive to China growth expectations. Qi provides macro driver sensitivity exposure, for a large factor information set, across the global single stock universe. We use this data to identify names most exposed to China. This is defined as the sensitivity to China GDP (+ve), Copper (+ve), Iron Ore (+ve), China 5y CDS (-ve), USDCNY (-ve) and VXEEM (-ve).

The performance of the 30 most exposed relative to the 30 least exposed in both regions is shown below. Note this is based on the prevailing sensitivities of stocks today – the names are fixed with no rebalancing. At any one time, risky assets are driven by a host of moving macro drivers, making a static screen somewhat naïve (see more details below).

However, the charts below make a simple point – DM equities exposed to China trade rich relative to the underlying Chinese equity market. This should not surprise, given the domestic growth / inflation focus. However, this is another example showcasing the reliance on a soft landing narrative

Qi has created a China exposure L/S equity basket using the S&P500 universe. This uses Qi’s proprietary optimisation process which looks at all the possible combinations of stocks and their weights that minimize the tracking error to the macro factor in question. This is run out-of-sample for a month, until the next monthly rebalance.

Qi baskets are available to trade via Goldman Sachs. Specifically, the chart below shows the performance of the GSQICFXS / GSQICFXL ratio.

The divergence in performance between the Qi L/S Basket and the CSI 300 (indeed also FXI) has extended since Q4 last year. Is now the time to play for re-convergence i.e. for a US investor to be long FXI and short China exposed US equities?

To provide clues Qi shows that the biggest driver of US equities outperformance over China today is inflation expectations: US wants disinflation to continue / China is looking for a way out of deflation. The sensitivity to inflation expectations for the ratio SPY / FXI is shown below.

In other words, for investors who are more concerned from here about inflation acceleration risk than China risk, this may present a timely mean-reversion opportunity. More details on this basket is available on request.

These conclusions are consistent with our recent screen of stock winners & losers in a soft landing scenario, where we screened sensitivities to growth expectations rather than inflation expectations.

The backbone is Qi’s macro factor sensitivity data across all S&P 500 stocks. From this data, we ran the following screen:

The result is the scatterplot above (click on chart above for a larger image).

The arrow highlights that the direction of travel for beneficiaries of disinflation and easier financial conditions is from the bottom-right to top-left. Specifically, Semiconductors are the most sensitive to inflation expectations and Banks to financial conditions.

Below is an alternative representation ranking the industries by their total exposure to these two drivers.

Leveraging the granularity of Qi’s data, we have the ability to also pinpoint exposures to the stock level in addition to any mispricing given the prevailing macro backdrop.

For an in-depth exploration of our screening process, from sectors to industries to individual stock analyses, feel free to reach out to the Qi team.

The S&P500’s Qi factor sensitivity to growth (GDP Nowcast, copper) and financial conditions (Fed QT expectations, HY credit spreads) to SPX stands at 1yr highs. Equities are increasingly reliant on what we saw late last year to continue. This picture is similar for other major indices. The Nasdaq 100 sensitivity to HY credit spreads and economic growth is also both at 1yrs highs – the two biggest drivers of the index.

The Qi S&P500 macro beta impulse is defined as the sum of the 4wk change in absolute sensitivities across all our macro factors, based on ST models. We plot that against the percentage deviation of the S&P500 from its 50d MA and invert that axis. See the chart below.

The premise is simple - as the gradient of macro factor sensitivities accelerates, the beta of the market to macro factors is rising. That is fine when the macro backdrop is moving in your favour but ordinarily Mr. Market struggles to digest the macro gyrations.

Note the dislocation that occurred over the most recent 8wk rally – the improving growth / inflation trade-off supported by the Fed “pivot” saw macro drivers move in favour of Qi’s models. The Beta Impulse rose but this time around S&P500 model price momentum was rising alongside this.

This backdrop creates vulnerability as the impulse rises ever further. Over the last few years, there appears to be a natural limit beyond which the beta impulse has peaked (ex-Covid). This is marked by the red line. Periods where have seen such as dislocation between price action and the beta impulse tend to re-converge, marked in the chart

Consider the Qi short term model of the S&P 500 – 93% model explanatory power and the model price starting to show signs of fatigue. We view model price as offering a true / less noisy representation of the market value than the spot price. Has the improvement in the growth / inflation trade-off already been priced?

In contrast, 2023 was about the improving growth / inflation trade-off aka Goldilocks, in the face of the naysayers calling for a hard landing after the fastest Fed tightening we had see in recent years.

During a disinflationary period, the fear of a late business cycle and the lagged impacts of policy is what matters for risk-off more than financial conditions. The S&P 500 in 2023 has an inverse relationship to its beta to growth relative to financial conditions. See the second chart below.

This should not surprise. If the economic backdrop was benign, investors will not be worried about growth i.e. sensitivities will remain relatively muted. When growth fears rise, the beta to growth will rise relative to other factors.

Today, under the hood, since early December the beta to growth has started to rise relative to financial conditions – how much tighter do we really expect credit spreads to get from here? In other words, the second chart suggests equities look rich relative to the growth / inflation trade-off – a similar level of confidence was also seen in late July. The bar is set high. Thus we would argue the market is trading on hope rather than fear into 2024.

Next year, the outlook is more poised on a knife-edge in our view. Street strategists simply extrapolate the last 3mth price action into their annual outlooks. The length of the runway for stocks will be dictated again by the growth / inflation trade-off and Qi offers the tools to expose this.

Qi's model for IGV has 79% confidence. This latest regime started at the beginning of May and confidence has been pretty stable since then.

On current patterns, the Software sector is dominated by a desire for reflation, rate volatility to remain contained and credit spreads to tighten. Software loves Goldilocks.

The Fair Value Gap is +1.1 standard deviations which currently translates into IGV standing 7.8% rich to overall macro conditions. In short, and from a pure macro perspective, a fair amount of good news is in the price.

The chart above shows IGV relative to semiconductors. The white line is the spot price of the IGV/SOXX ratio; the red line is Qi's macro-warranted model value for the pair. 

Once again IGV wants reflation. Higher inflation expectations are consistent with Software outperforming Semis. The recent fall in inflation expectations are the biggest reason for the 3% fall in Qi model value over the last month.

That decline in model fair value stands in sharp contrast to the recent spate of IGV outperformance. Hence a 8.7% rich valuation on Qi.

And finally we show Software versus the broader market by modelling the IGV/SPY ratio.

The desire for reflation is there again but this time other factors have worked to offset the drag from falling inflation expectations. The net result is macro momentum has eeked out a 0.9% gain on the month. 

And once again, the recent rally in IGV has outstripped where aggregate macro conditions say it 'should' trade. Software screens as 6.5% rich relative to the S&P500 on Qi.

This is not to dispute the idea that the second wave of the AI revolution could provide a huge benefit to software stocks. The AI theme is not going away in 2024.

It is a warning that, should the mood of the market turn down, then IGV looks vulnerable from a tactical perspective. More specifically any scenario that speaks to sticky inflation, rising bond vol and wider credit spreads poses a risk.

Even bottom-up or thematic investors should know that, with Payrolls on Friday and the Fed meeting next Wednesday, the macro angle needs to be factored in.