Morgan Stanley Warns of 5% Market Correction Amid Slowing Fund Inflows

Morgan Stanley's quantitative analysts have observed a deceleration in capital inflows into the U.S. stock market during the latter half of July. This slowdown in passive fund inflows, combined with several significant events expected to occur by the end of the month, could potentially trigger a short-term market correction of around 5%.

The analysts note that the momentum of the recent market rebound has weakened. The daily inflow of retail funds has decreased from 350 million dollars at the beginning of the month to the current level. This deceleration in fund inflows, coupled with the upcoming catalysts, could make the market more vulnerable to external shocks. The analysts caution that any negative factors, such as disappointing earnings reports, unfavorable macroeconomic data, or adverse changes in trade policies, could exacerbate this situation and lead to a more significant market adjustment.

Despite the potential for a short-term correction, the overall outlook remains optimistic. The analysts believe that any market pullback will be brief and present an attractive entry point for investors to capitalize on the anticipated earnings growth. The recent market rally, driven by the resilience of U.S. corporations and the economy in the face of uncertain trade policies, has added approximately 11.5 trillion dollars to the market value of the S&P 500 index. This surge follows a period of volatility in early April, when the index was on the brink of a bear market due to widespread tariffs imposed by the administration.

The analysts anticipate that the third quarter could be a period of heightened risk as the impact of tariffs begins to reflect in sales costs. However, they expect this effect to be temporary, with investors quickly shifting their focus to the anticipated growth in 2026. The analysts emphasize that despite the uncertainty surrounding trade policies, the market is expected to continue its upward trajectory. They highlight that the market has already bottomed out in April, with all indicators showing a sharp turnaround and exceeding expectations.

In addition to the slowdown in retail fund inflows, the analysts also note a potential decrease in systematic strategy buying. While systematic strategies have been significant buyers in the past week, maintaining a daily purchase volume of over 500 million dollars, this is expected to halve to 250 million dollars by the end of the month. Furthermore, many companies are currently in a stock buyback blackout period, which is expected to ease by early August. This could potentially add to the market's vulnerability during this period.

On the other hand, hedge funds' net exposure remains at a moderate level, providing some support to the market. With net exposure currently at 51%, which is at the historical median, and U.S. long-short strategies having recorded a 4.9% gain so far this year, there is room for further increases in exposure. This suggests that hedge funds may need to increase their holdings before the market turns downward, potentially driving a "higher first, then lower" dynamic. Additionally, in the event of a market downturn, traders' gamma exposure is expected to increase, which could provide further support to the market.

Looking ahead to the end of the month, several potential market-moving events are on the horizon. These include the Federal Reserve's decision, the non-farm payroll data release, and the approaching deadline for tariffs. More importantly, companies representing 40% of the S&P 500's market capitalization are scheduled to release their earnings reports in the last week of July. Historical data suggests that when a large number of high market capitalization companies release their earnings on the same day, the S&P 500's absolute return tends to be larger and slightly negative. Additionally, there is an estimated 170 million dollars of asset allocation supply pressure expected. The combination of these factors could trigger a market correction if there is any noise from earnings reports, macroeconomic data, or changes in trade policies.