Market internals were volatile in May (HERE), but the broader macro backdrop remains firmly in a Normal economic expansion regime. Based on our Macro Regime Classification Model, recent geopolitical developments and the Iran War shock have not translated into a meaningful increase in recession risk. Most macro variables remain firmly in their normal ranges. One notable exception is credit spreads, which are extremely low relative to history. The current spread level suggests investors are assigning a very low probability of an imminent economic downturn.
Under a normal expansionary backdrop, the S&P has typically generated steady gains, and the current cycle continues to closely track those historical episodes. At the same time, the 10yr yield has generally been stable or drifted modestly lower during extended Normal regimes. While inflation concerns and Fed repricing pushed yields higher in mid-May, our base case remains that 10-year yields are unlikely to move materially higher as long as the expansion remains intact.
Inflation remains the primary macro risk identified in our investor survey (HERE). While current inflation levels do not suggest heightened recession risk, sustained inflation surprise could tighten financial conditions and trigger meaningful market rotation. Under a scenario where core PCE rises 0.3% monthly through year-end, core inflation would approach 3.8% YoY by the end of 2026, potentially requiring a more restrictive Fed stance. Although this is not our base case, higher inflation remains the most important risk to monitor.
Should tighter financial conditions emerge, leadership within equities would likely shift. Historically, Low Volatility and Quality of Earnings factors have benefited from rising financial constraints, while Risk-On and Earnings Growth exposures have underperformed. At the sector level, Energy, Banks, and Insurance appear best positioned to benefit from a higher-inflation environment, while AI-driven winners such as Semiconductors and Technology Hardware would face relative headwinds.
In short, the key risk from higher inflation remains rotation rather than recession, with the macro regime still signaling continued expansion, constructive equity performance, and contained 10yr yield.
Macro Regime Remains Supportive Despite Inflation Risk: Though internal market regimes were volatile in May (HERE), the macro backdrop remained in a stable Normal economic expansion regime. Based on our Macro Regime Classification Model, the current economic expansion started in Mar of 2024. The war shock has done little to increase Recession risk as consumer trends and economic growth remain resilient.
The latest macro data reinforces the normal expansionary regime classification. Most economic series are in their normal ranges (1 Std range). The most notable outlier is credit spreads, which remain at an extremely low level relative to history. Credit markets have historically been among the most effective forward-looking recession indicators, and the current spread implies that investors are demanding very little compensation for default risk, implying that the market is not pricing an imminent recession.
Historical analysis of consecutive Normal regimes suggests a constructive backdrop for risk assets, as the S&P has generally delivered positive returns throughout the duration of sustained Normal regimes. The current cycle, which began in March 2024, closely resembles prior Normal periods. As a result, equities will be likely to grind higher as long as the macro regime remains stable.
For the bond market, 10yr yield has generally remained stable or drifted modestly lower during extended Normal periods, rather than undergoing sustained and significant increases. Though yield spiked higher in mid-May on inflation concerns and repricing of Fed policy, the broader macro framework suggests the 10y yield is unlike to move higher further. Our Economic Analyst, Peter Williams sees fair value for 10yr yields at 4.25–4.5%.
According to our investor survey, inflation and rates are the biggest risk to the macro backdrop (HERE). Investors are especially worried about inflation. Oil shocks and closure of the Strait of Hormuz (SOH) continue to bring uncertainty about the direction of price levels. Inflation readings at their current level do not suggest increased near-term recession, but does increase the odds that financial conditions tighten. That is more about market internal rotations than overall market direction.
An 0.3% monthly increase in core PCE through year end would bring the y/y reading to 3.8% at the end of 2026. At that level we would expect to see the Fed tighten financial conditions to slow growth and rein in inflation. That is not our base case now as we expect growth will slow organically, allowing the Fed to leave financial conditions near their current accommodation level. The point here is to put numbers (0.3% m/m core PCE readings) around what would constitute inflation higher enough to trigger a shift in Fed policy.
If inflation were to surprise to the upside with tighter financial conditions needed, Low Volatility and Quality of Earnings are likely to reverse higher while Risk-on and Earnings Growth, which are performing well, would face downside risk. Momentum and Size factors used to have positive sensitivity to financial conditions while AI idio risk has weighed more on their returns this year, which may be less driven by financial conditions now.
Semis and Tech Hardware are the best performing industry groups this year on the massive AI buildout. Those groups have negative sensitivity to financial conditions. If core inflation prints 0.3% or higher, Semis and Tech Hardware would face headwinds while Energy, Banks and Insurance are more likely to be benefit.
