Keep your eye on inflation expectations, Chinese yuan, volatility, Morgan Stanley cautions

The rally in global equities over the preceeding month had taken investors by surprise, coming as it did right after the referendum vote opened-up a proverbial 'Pandora´s Box' of political uncertainty, but several developments in global capital markets warranted watching, Morgan Stanley´s strategy team said.

Nonetheless, Secker did concede that the rally had taken place against the backdrop of the G10 economic surprise index rising to a two-and-a-half-year high.

Indeed, "surprisingly, the UK currently has the highest economic surprise index reading of any major region", he said.

Among the developments to monitor were:

1. Five-year, five-year inflation breakevens Stateside started to fall in the latest week, after having risen before, which would make the rally in stocks look vulnerable if that trend continued.

In that regard, Secker noted how the Chinese yuan - a key driver of inflation expectations in 2016 - had been making new lows of late on a trade-weighted basis.

2. The Chicago Board of Options Exchange´s volatility index, or VIX, the acronym by which it was known in markets, had plummeted below the 12.0-point level to close to record-lows despite "high" political uncertainty.

"If the recent spike in policy uncertainty normalises soon, then this current disconnect is not particularly worrisome for markets; however, such a scenario strikes us being rather optimistic," Secker said.

3. At 22.0%, net short positioning in the VIX was at its lowest in three years. Troughs in that speculative positioning usually coincided with tactical peaks in markets, the strategist pointed out. Since 2010, on the other ocassions when the VIX had hit similar levels, on average declines of 2% in European equities ensued over the subsequent one and three months, he added.

4. Investors had gone net long both US equities and US Treasuries by two standard deviations. Such an occurence had only been witnessed three times over the past 30 years, in 2000, 2006 and 2012. For its part, the RSI for the German Dax had moved above 70 and the broker´s Global Risk Demand Index (GRDI) was above +1 standard deviations.

5. The breadth of the outperformance by high-Beta stocks had been the greatest since 2012, with 87.0% of European high-Beta shares outperforming over the last month. That has also been seen three times in the past, in April 2009, March 2010 and January 2012.