I tried all the lighting settings you mentioned, and turned off the Mesh Distance Fields. Nothing worked.
The reason you weren’t able to reproduce the issue is because you didn’t scale the instanced mesh. The problem only occurs when you (1) have an instanced mesh component and (2) you scale an instance non-uniformly.
Look at my [forum thread][1] in which I prove that this is a normals issue. In the thread, if you look at the GIFs, I compare the normals on an instanced mesh (top) against the normals of a plain static mesh (bottom). Just two meshes.
What’s happening is that instanced meshes do not compute their tangent basis vectors correctly if the instance is non-uniformly scaled. As you pointed out before, this might not be a bug, but rather a performance optimization.
My point is that this leaves a rather large functional hole in the engine. Maybe we could have a bool on the instanced mesh component that, if set, would ignore the scale while transforming the per-instance normals. That way, we would get both, the performance and the correct normals.
Finally, to illustrate the problem, you can even see the normal difference between a instanced mesh (top) and a static mesh (bottom) in the Blueprint Viewport Approach:
