SINGAPORE (Sept 19): The odds of capitulation in stock markets are rising, with macro hedge funds pricing in a more extreme scenario for a global sell-off, according to Morgan Stanley's quant strategists.

Global macro investors are expecting elements of market dislocation, as they remain "net short on equities, and are targeting a tactical risk [for the US terminal rate to go beyond 5% and for the US treasury 10Y yield to go beyond 4%]", strategists including Gilbert Wong wrote in a note. "Being overweight cash is the best way to hedge."

Funds are targeting Asia/EM and US equity valuations to decline 5%-6% from current levels, which implies the MSCI Emerging Market Index at a near bear case target of 890 and a new year-to-date low of 3,600 for the S&P 500 Index, according to the US investment bank's calculations.

Bearishness has risen since the US announced hotter-than-expected inflation data, but may get more extreme in the near term, as short positions have been covered amid declines and volatility remains well below levels seen at peak market fear moments.

Aggressive interest-rate increases by key central banks, with the exception of China and Japan, have pushed global economies to the brink of recession and stock markets toward bear markets. After dreaming of a dovish pivot for a long time, investors are waking up to the grim reality of weathering continued jumbo hikes in an effort to stamp out inflation.

Wong and his colleagues advise investors to "to stay defensive until capitulation" occurs. They recommend adding quality growth stocks amid any sell-off and avoid shares with attributes of low quality and unprofitable growth.