FYI Model Adjustment Notice: Beginning July 2026, the Commodity index input CRB RIND Index has been replaced with the SPGSNETR Index due to data discontinuation. The revised model maintains 91% historical classification agreement with the prior model, with all prior Transition and Recession classifications in place.
Concerns over a prolonged Fed tightening cycle have increased, but our macro regime model continues to classify the current environment as a Normal expansion, with both macro and market conditions well within their historical ranges. Although implied equity vol has increased as investors reassess the path of inflation and Fed policy, the deterioration reflects greater uncertainty rather than a meaningful weakening of economic data.
As we mentioned (HERE), the S&P has generally delivered positive returns throughout the duration of sustained Normal regimes. During these periods, sales growth has been the primary driver of S&P 1500 returns, supplemented by steady margin expansion, while valuation multiples have remained relatively stable. The current cycle continues to follow this pattern. By contrast, Transition and Recession regimes have historically been marked by contracting margins and significant multiple compression. Under the current Normal expansion, sales and margins should continue to expand during the upcoming 2Q reporting season, and economic trends favor stronger than expected for SPS and EPS readings.
Currently, almost all macro variables are around normal levels, except for credit spreads. Moody’s BAA-AAA spreads are near their tightest level in more than four decades, suggesting limited room for further compression. While spreads could gradually normalize as policy uncertainty persists, it is unusual to see sustained sharp credit spread widening during Normal expansions periods.
Overall, the combination of stable macro conditions, healthy corporate fundamentals, and low recession risk continue to support a constructive outlook for equities despite elevated near-term volatility.
Improving Fundamentals the Major Driver of Market Gains: Concerns about a possible Fed tightening cycle are weighing on risk assets, but the underlying macro backdrop has remained largely unchanged. Both market and macro conditions suggest a continued Normal economic expansion. Recent market performance has been driven primarily by the AI investment theme, pushing the latest market conditions reading toward the upper end of the historical Normal distribution and further away from the ranges typically observed during Transition or Recession regimes.
Though macro conditions remain stable, uncertainty has increased, reflected in higher implied equity volatility. Based on Strategy team’s view (HERE), investors are discounting the possibility of a rate hike in 2026 because core inflation trends remain too strong. The policy path remains data dependent, and current policy remains supportive of growth. The uncertainty in markets is due to the increased risk that policy could turn restrictive.
As we mentioned (HERE), equities tend to perform well throughout Normal economic expansions. The driver of index gains during Normal expansions has been improving corporate fundamentals, particularly sales growth, while margin expansion provided additional support. The current cycle, which started in 2024 continues to fall into that historical pattern with sales and margin changes the main contributors to gains. That is in line with strong earnings expectation this year. Consensus estimates of S&P EPS for CY26 are $343, +14.5% y/y.
By comparison, margins drop during historical Transition and Recession periods and multiples tend to contract. Currently, we continue to see expanded sales and margins, particularly among AI-related companies, which is inconsistent with a near term Recession.
With 2Q earnings season about to kick off in two weeks, we should expect the earnings and sales to again beat expectations by a significant margin with most names beating their estimates in the current Normal expansion backdrop.
Credit Spreads Remain Outlier Good: Almost all the macro variables are within their normal ranges, with credit spread (measured as spread of Moody’s Corporate BAA – AAA) is the only outlier. Spreads are currently at their tightest level since at least 1984. The extreme tightness of spreads and the strong uptick in capex suggests spreads should widen from here. However, it is rare for spreads to widen materially and persistently during economic expansions. With objective recession odds low, spreads should remain well behaved.
Credit spread moves during historical Normal cycles have been varied directionally, but have generally remained range-bound, with relatively few episodes of sustained or abrupt widening. This historical behavior suggests that even if credit spreads begin to normalize from today’s unusually tight levels, the adjustment is more likely to be gradual than indicative of an imminent economic downturn.
