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Having fallen out of regime late in August - & flagged the increased volatility experienced over September – the S&P500 has now seen model confidence rise by 35% in the last 4 weeks. We’re not quite there, but a new macro regime is on the verge of being formed. What's driving the new regime? First & foremost US equity bulls need tight credit spreads.

In addition, the new regime shows SPX rises when Fed rate expectations rise & the yield curve flattens. While a flatter yield curve suggests the bond market is worried about forward growth, the equity market see’s a Fed policy stance that is ahead of the curve.

A pre-emptive Fed that hikes earlier, means less rate hikes overall. Money markets might be pricing a higher terminal rate than before, but it’s still a contained hiking cycle relatively speaking.

The real policy error is a Fed that’s behind the inflation curve. Policy that is too lax for too long means the bond vigilantes steepen the yield curve & that’s a negative for US equities on current patterns.

This is not yet a confirmed regime & factor leadership could yet evolve further before model confidence crosses the 65% threshold. One dynamic we are watching closely is a new pattern of negative sensitivity to inflation expectations. That implies “bad” inflation for equity markets – the type that compresses margins &/or forces a Fed policy response (one with a higher terminal rate).

Tracking these shifting relationships is tricky but Qi provides a transparent framework.

As we enter earnings season it is evident that the inflation dynamic continues to deteriorate for US single stocks. “US equities & inflation - a regime shift?” first flagged the shifting pattern by isolating individual stocks independent sensitivity to inflation expectations.

The orange line showing the number of stocks with positive sensitivity to US inflation expectations has fallen to a fresh low. Just 117 S&P500 stocks in macro regimes now see rising inflation as a tailwind for performance. That’s around a third of the total that were enjoying the reflation bounce in Q1.

Back in March, the number of stocks in regime with a negative relationship (“headwind”) was effectively zero - the reflation narrative was all encompassing. Now that number is 41.

That total of 158 stocks shows the degree to which US equities remain out of regime. Currently non-macro factors are bigger drivers of price action than economic fundamentals, financial conditions or risk appetite. Qi has repeatedly demonstrated that leaves the market more vulnerable to transient factors like positioning, flow & sentiment – all of which are inherently more susceptible to bouts of volatility.

At the index level, model confidence for the S&P500 is now back at 50%, up 34% in the last 2 weeks alone. A new macro regime appears to be forming & sensitivity to inflation has just edged into negative territory. A major macro shift appears to be on the cusp of confirmation.

Increased freight & warehouse costs could yet compress margins but, for those anticipating decent volumes in the months ahead, it is worth noting that, on Qi, US retailers (XRT) currently screen as cheap versus the broader market (SPY).

The XRT vs. SPY ratio is 6.25% below macro-warranted model value. That’s the biggest deficit to macro fair value in the last year.

It is also a statistically significant level. There have only been 10 instances since 2009 where XRT vs. SPY has been this far below model fair value when in regime. Buying the dip at that level elicits a 60% hit rate for an average return of +0.8%.

The macro regime is all about domestic & global reflation. Retailers outperform the broader market when US real rates are rising, the yield curve is steepening & when global growth (China GDP plus commodities) are robust. A strong Dollar is the biggest single negative.

For those who believe in US consumers & their appetite to fuel a robust shopping season, this looks like an attractive entry level to play upside amongst US retail stocks.

The chart shows US & European 5y inflation expectations in z-score terms. Both are running above long term trend but the most noticeable feature for the last month plus had been the divergence between the two.

The global energy crunch hit Europe harder which experienced a 2 standard deviation move in inflation expectations. That erosion in real yield support was negative for the Euro & helped push macro fair value for EURUSD down towards 1.15. If this re-convergence proves sustainable, the 3 month downtrend in macro-warranted model value for EURUSD could be coming to an end.

This catch up in US inflation expectations will have broader implications. Which are the best inflation hedges currently? Qi’s “Commodity Super Cycle” watchlist suggests commodity energy markets are rich (though not in regime), while most commodity currencies have already priced a degree of good news. Base metals & certain mining stocks (Freeport, FCX & copper miners ETF, COPX) have lagged, sit in regime & at macro fair value.

Furthermore, Q3 earnings season will no doubt focus market attention on those stocks that enjoy pricing power versus those experiencing margin compression. Equity investors know their style tilt – the degree to which their portfolio favours growth over value, momentum or quality – but can they quantify the relationship their holdings have with inflation expectations?

It’s geeky but, in short, negative basis swaps imply the cost of accessing USD funding is becoming more expensive for foreign banks. In the chart below for example, note the huge spike lower / squeeze in USD liquidity in March 2020 with the first economic lockdowns.

The chart shows USDJPY cross-currency basis specifically & in z-score terms. So the recent sudden leg lower below the zero bound implies tighter USD liquidity for Japanese institutions.

Any asset with a positive relationship to this factor needs easier USD liquidity to perform; & conversely, will suffer as US liquidity tightens.

The US debt ceiling issue was threatening to become a meaningful headwind for such assets given the factor move above. That move may abate near term but could easily re-appear as a critical driver of markets if the whole stand-off is repeated come December.

It’s early days but S&P500 model confidence has risen 24% in the last 2weeks suggesting a new macro regime could be forming & cross currency basis swaps feature as a top driver. If that relationship holds, another significant tightening of US liquidity in December could be a far bigger deal for US equity markets.

That represents a perfect round trip since “Suga high” on September 6th when the Nikkei was 1.3 sigma (4.1%) rich on Qi. That flag was a little early (the Nikkei peaked a week later) but the message was simple – while politics had powered the rally, Japanese equities were in a strong macro regime & at valuations that look stretched. What’s the macro picture now?

Nikkei model confidence dipped (in line with its global peers) but critically stayed in a macro regime – a regime that emphasises domestic reflation (rising inflation expectations & a steeper yield curve) & easy financial conditions (Central Bank QE & tight credit spreads).

That combination of macro factors are offsetting each other such that macro model value is currently moving sideways. Hence the sudden & substantial Fair Value Gap.

How significant is this FVG level historically? Since 2009 there have been 13 occasions when the Nikkei has been in regime & 1.3 sigma cheap to model. Buying the dip has produced an impressive 85% hit rate for an average return of +7.6%.

As always, this time could be different. It feels like equity bears are gathering a bit of momentum right now. But it ‘felt’ like Suga’s resignation was going to be the catalyst for the great Japanese catch-up trade. For those who believe this is merely a correction, one of the world’s most cyclical assets is presenting an interesting opportunity.