S&P 500 risks 11% drop on trade war warns Morgan Stanley’s Wilson

Investing.com -- The equity rally that began in April is at risk of a sharper pullback as trade tensions with China escalate, Morgan Stanley’s Michael Wilson warns, with technical levels pointing to an 11% decline if there is no de-escalation in the coming weeks.

Wilson notes that a setup for a correction was already “in place given elevated positioning, valuation anxiety, and unfavorable seasonals,” and the unexpected trade conflict has acted as the catalyst.

Expectations for a China trade deal coming out of APEC, combined with decelerating earnings revisions breadth into reporting season, had already contributed to price weakness before the tariff shock hit.

Friday’s sell-off hit crowded longs and cyclical sectors hardest, amplified by high hedge fund and systematic exposure. With neither Washington nor Beijing showing signs of backing down ahead of the November 1 deadline, volatility is likely to linger.

“If we don’t see de-escalation into early November, we think this correction is likely to be larger than most are expecting,” Wilson writes, putting the potential drawdown at 10-15% based on key retracement levels.

“A 38% retracement of the first leg up would be 6027, 11% below recent highs,” a level that coincides with the 200-day moving average and would fill a technical gap left in June. Wilson flags 5800, around 15% below recent highs, as the next durable support if that first level gives way.

The bear case outlined by the bank assumes that an additional 100% U.S. tariff on Chinese goods is implemented and stays in place, while China responds with broad rare earth export controls.

Such an outcome would resemble a trade embargo and would undermine the bank’s early-cycle recovery narrative.

Morgan Stanley still frames the current weakness as a correction within a new bull market that started in April, but warns that the path will be volatile if policy uncertainty persists.

Wilson points to fading global dollar liquidity and points out that tactical positioning remains stretched in sectors directly exposed to trade conflict, such as crowded stocks, semiconductors, and quantum computing.

In terms of portfolio stance, the strategist reiterates that quality remains the best hedge against policy risk. Healthcare is the preferred defensive sector, while Consumer Discretionary remains underweight due to its “outsized China tariff cost exposure.”

If tensions ease and markets find a floor, Wilson expects the broader recovery trend into 2026 to resume.