Shares of Smart & Final (SFS) - Get Smart & Final Stores, Inc. Report are sliding after Morgan Stanley analyst Vincent Sinisi downgraded the stock to Underweight, a sell-equivalent rating, on greater pressure and uncertainty over the medium-term. While the analyst expects deflation and associated competition to continue to weigh on food retailers, he sees Kroger (KR) - Get Kroger Co. (KR) Report and Sprouts Farmers Market (SFM) - Get Sprouts Farmers Markets, Inc. Report as best-positioned once inflation rebounds.

SELL SMART & FINAL: Morgan Stanley's Sinisi believes food retailers are operating in a difficult macro environment, which creates investor fatigue. Deflation and associated competition continues to weigh on the retailers who are forced to invest in price to drive sales, the analyst told investors in a research note. Further, Sinisi said he believes a return to second half of 2016 inflation is less likely, supporting a more "tempered" outlook on the subsector. This morning, the analyst downgraded Smart & Final to Underweight from Equal Weight, citing its worse than expected second quarter results and reduced guidance, and noting that he believes the company's higher leverage and lower margins than its peers creates outsized risk. Moreover, he still sees further downside to consensus estimates and growing risks related to the company's exposure to California.

BEST POSITIONED: Despite the "tough" backdrop for food retailers, Sinisi remains bullish on Kroger and Sprouts. He sees both stocks as best positioned to benefit when the sector improves. The analyst believes the deflation cycle will eventually turn, leading investors to focus on companies with "leading fundamentals." Sinisi continues to like the growth and share gain potential of Kroger and Sprouts, noting that their long-term fundamental strengths should remain intact regardless of the macro cycle.

PRICE ACTION: In morning trading, shares of Smart & Final have dropped over 3% to $13.63.

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Reporting done by Jessica de Sa-Mota.