Institutional Insights: Nomura – The Possible Post Tariff Pain Trade Playbook

According to Nomura's flow guru McElligot - The market seems to be signalling a clear expectation of lower equity prices, as evidenced by the prevalent "Defensive / Hedged / Low Net Exposure" positioning. Some investors are now contemplating how far equities might decline before they can capitalize on a potential "buy the dip" opportunity for another tradable bounce. This mindset is rooted in the moral hazard environment we operate in, where worsening conditions often prompt increasingly asymmetric policy responses—be it fiscal measures from politicians or monetary interventions from central bankers.

In line with the market's recent tendency to defy consensus and exploit groupthink, a potential "pain trade" could emerge. Following an initial market surge, equities may rise due to a reflexive "less severe than anticipated" or "not the worst-case scenario" reaction. This could hinder investors from recognising a significant dip as an opportunity to buy, resulting in a rally that may surprise many. Such a dynamic might trigger behavioral "short gamma" effects to the upside, with investors scrambling to chase the rally and buying as prices climb.

This scenario could be further fueled by systematic strategies being forced into higher prices, options dealers covering short puts on major stocks, and leveraged ETF rebalancing demand during rallies—which tends to outpace supply during downside moves by approximately 1.5 times. Meanwhile, hedges could be unwound, driving short delta positions to be bought back, amplifying the upward momentum.

The second phase of this hypothetical "pain trade" would emerge as the real impact—both psychological and tangible—of the tariffs starts to manifest. This could be reflected in weaker U.S. growth data or profit warnings and guidance cuts from American corporations. Consequently, recent buyers might find themselves caught holding the bag, leading equities to decline further as derisking flows intensify.

To summarize, the bleak scenario unfolds as follows: equities initially spike higher in a kneejerk reaction when sentiment is overwhelmingly bearish. This rally is fueled by mechanical, unemotional systematic flows creating demand, potentially pulling in fundamental investors who were initially hesitant. However, the reality of slowing growth eventually sets in, triggering a sharp correction in stocks from those elevated levels.