Morgan Stanley SALES & TRADING COMMENTARY

Some market stabilization provides a window to shift focus from risk management to forward planning. The “fast money” has already exited – hedge fund net exposures hit 37% on Friday (now at 39%, 2nd percentile since 2010), and macro systematic leverage has dropped to the 14th percentile after selling $375 billion in equities. However, retail investors and long-only funds, according to QDS estimates, have yet to capitulate. A key question from a flows perspective is the behavior of foreign investors. A major bearish scenario would involve ex-US real money reversing 20 years of inflows into US markets. To hedge this risk, investors could consider selling MSXXFOWN – a basket of US stocks with high foreign ownership and significant recent foreign buying, which has shown a strong correlation to US equity inflows and outflows.

QDS’s tactical outlook suggests:

a) Equities are more likely to rise than fall over the next week.

b) Over the coming months, markets may re-test or hit new lows as the tariff shock’s impact unfolds and slower-moving investors sell equities.

While some capitulation signals have emerged (e.g., hedge fund net exposures below 40%, intraday VIX above 50), a full high-correlation selloff has not yet occurred. The likely market bottom, barring a tariff reversal, would involve a highly correlated decline across asset classes – with the dollar, bonds, and equities all dropping simultaneously, pushing correlation above 80% (it reached only 60% last Friday). Such an event could prompt the Federal Reserve to restart quantitative easing or cut rates. Until that point, investors should reset hedges during rallies, sell stocks more vulnerable to a growth slowdown or recession (MSXXRCYC), and reduce exposure to stocks at risk from US outflows (MSXXFOWN).

Looking ahead, QDS is focusing on four key themes – the “4 F’s”:

1. Fundamentals: The full impact of tariffs will take months to materialize, but market indicators provide clues. Historically, a 20% decline in the S&P 500 has signaled a recession in 9 out of 13 instances and an earnings-per-share (EPS) drop of over 10%. Investors should sell MSXXRCYC, a basket of cyclicals exposed to recession risks.

2. Fed: Will the Federal Reserve respond proactively to a growth slowdown or lag behind? Powell’s recent comments suggest a lack of urgency, meaning the Fed could act late if growth weakens. Until the Fed pivots or tariff policies are reversed, selling S&P 500 rallies is advisable.

3. Foreign Flows: Among various flow dynamics, the actions of ex-US real money investors carry the most downside risk. Selling MSXXFOWN, a basket of stocks with high foreign ownership and recent foreign buying activity, could help mitigate this risk.

4. Financial Leverage: While significant deleveraging has occurred, some leverage remains, and the market is short gamma. Implied volatility is currently elevated, but gamma becomes attractive on market dips. Investors should note that post-shock upside moves can outpace downside moves – consider long calls or short delta strategies.

In summary, the market presents opportunities to tactically adjust positions, hedge risks, and prepare for potential volatility while keeping an eye on the evolving macroeconomic landscape.