Bear Market to ATHs, Large and Small Cap, Earnings, and Election Year

Chris Wallis, CEO and CIO at Vaughan Nelson, reviews the bear market and all-time highs, the gap between large and small cap stocks, earnings season takeaways, 4Q23 GDP boost, and election year market impact.

January 31, 2024

Lightly edited transcript

Dan: Welcome to the Vaughan Nelson podcast. With me today is CEO and CIO, Chris Wallis. Welcome Chris.

Chris Wallis: It’s great to be here, Dan.

Dan: All right. Chris, let’s jump right into it. Here we go. We’re at the end of January. And we’ve once again hit all-time highs. And now I’m looking back over the last let’s call it two years or so, thinking about our discussions about bear market. Do you think that this was just a standard bear market, right? We saw a 25% correction. We saw a fairly quick bounce back. And now here we are again sitting at new highs.

Chris Wallis: Look, I still think, as I’ve tried to describe it, is the world’s out of balance. And the initial adjustment really was repricing capital, pricing in more fiscal dominance into the economy, which comes with higher levels of inflation. We saw that initial drawdown. And what we’ve seen now is just a little bit of a reciprocal bounce in that. My own view is we’re still out of balance. So if you think through inflation, inflation typically comes in cycles. So we had the first up wave of inflation. Now inflation’s rolled over. And the market is saying, “Look, we can bring down rates. We can bring down real rates. And we can go back perhaps to the world we were before.” I just don’t think that’s going to be the case. Inflation is coming down aggressively. We’ve seen that in the data. That’s no longer the issue.

Chris Wallis: And we’ve moved back up to the upper range. The other part of this is it’s still driven by flows in liquidity. And liquidity bottomed in October of ’22. And with that, that’s put a floor under the markets. And markets have moved higher. And we now have the US, the ECB, the BOJ, and the PBOC all boosting liquidity. So I think that has a lot to do with why we’ve moved up to new highs. All of our growth is still driven by fiscal dominance. You can certainly see increases in activity around AI. We’re still getting to the end stage of an industrial slowdown, but I think the standard bear market may apply to the repricing we saw in fixed income and in real estate. Equities, let’s see where inflation is in ’25 and beyond before we declare victory in just a two-year bear market.

Dan: Yep. Good. And just talking about the markets general, again, looking at the S&P, and looking at the Russell 2000, we’ll just use those as proxies for large and for small cap, the gap is still really significant. And this is even after we saw roughly 15% fourth quarter rally for small caps. Do you think that small caps are being held down by rates? And if you saw a rate cut, would you expect to see small caps start to accelerate?

Chris Wallis: Look, I think the difference in the performance between small caps and large caps is one, just the cap-weighted nature, and who the leadership is in the S&P 500. And you’ve seen the largest tech stocks perform incredibly well for the last year, and rightfully so. Their fundamentals are incredibly strong. There’s no question that the higher cost to capital hurts small caps. And when you look at earnings year-over-year, Russell 2000 earnings are probably down so far 28% year-over-year. That’s not the case with the S&P 500. So it’s just a very different environment in a very different world. Yes, rate cuts may be on the horizon, but the market’s already cut rates. We’ve already seen over a hundred basis point decline in the 10-year right? Rates have been cut by the market. We saw a significant easing in financial conditions, which is why we got the fourth quarter cyclical rally that we did.

Chris Wallis: So anything the Fed does from here is just going to follow what the market’s already expecting. So look, I think we may get rate cuts. I think the 10-year at 4% is where it should be either going to be a hundred basis points higher or lower over the next couple of years, because we’re either going to tame inflation, and maybe have to deal with our structural deficits a little bit, which would put us at the lower end of that range. Conversely, if we keep ramping up fiscal spend, we may see higher inflation in the 10-year back at 5%. So I don’t look to rate cuts to be a catalyst to close the gap. It’s going to take a recovery in industrial activity. It’s going to take a recovery in consumer cyclicals, all areas that are in and remain in a bear market for their earnings.

Dan: All right. Let’s shift over to earnings, since you’re discussing it, right? So we’re a couple weeks now into earnings season. Any major takeaways? Anything you’d point out so far?

Chris Wallis: Yeah. Look, the strength we’re seeing in technology is really only related to the AI spend, both with increased CapEx, and the need for infrastructure being chip infrastructure. And that’s where we’re seeing the strength. Elsewhere, we’re seeing, because we’ve seen such a significant decline in inflation that is pricing power. So we’re seeing margin pressures, and we’re seeing cost cuts, which is the natural evolution to any slowdown. You get revenue pressure. How are we going to hit estimates? We’re going to start layoffs. And they haven’t been significant, but they’ve been across nearly all the sectors we’ve seen layoffs be announced. And we’re going to focus on cost cuts. As we’ve said, we expect a weak Q1, a weak Q2, and then more stability. So I think we’ll be bringing down estimates. And then it’s all going to come down in ’24 to what’s the inflection in economic growth in the back half of the year? And that is going to have a significant impact on the performance broadly ex the Mag Seven that are driving the S&P 500.

Dan: And then let’s talk a bit about GDP. So we saw a pretty large boost to the fourth quarter GDP, and that came from a bit of an outsized decline in the GDP deflator. Does this change your view on inflation right now?

Chris Wallis: It doesn’t. Look, I think inflation has come down dramatically. I think a lot of the economic data that we are getting is still heavily influenced by the impact of COVID, and the seasonal adjustments, and the influence that the significant volatility in economic data had in ’21. So that’s why we see a bigger gap as we do between GDI and GDP. It’s why we’re seeing anomalies in and around employment weakness, and other elements. And I think it’s going to play through in inflation as well. So the data is going to remain volatile. And you’re going to get these unexpected significant outliers. And I think the Q4 GDP deflator was just another one of those. Look, inflation is falling. There’s no doubt about it, but we’re starting to stabilize.

Chris Wallis: So we have base effects that have been a tailwind, and those start to ease. And as we get into Q4 of this year, there’s an opportunity for inflation to tick higher. There’s a tug of war going on between a very weak environment and disinflationary turning into deflationary conditions out of China, and the rest of the developed world experiencing a firming of inflation fundamentals. So it’s going to be an interesting Q4 on that, but I don’t think inflation is going to be an issue for the first two or three quarters. And as I said, it’s come down pretty dramatically.

Dan: All right. So this one’s a little bit going to be further out in the view, but it’s 2024. We’re in election year, election year cycle, but we’re already starting to see some pretty meaningful news that’s coming out. Political rhetoric, that’s starting to ramp up. And just last week, we saw President Biden, he announced a delay and enhanced review process for new liquid natural gas export facilities. Prior election years, we’ve started to see that elections were not nearly as important as the pundits would like for us to think. But do you think that the elections in 2024 will be a little bit different? Do you think they’ll be significantly important for the markets?

Chris Wallis: Yeah. Look, I tend to not pay a lot of attention to the elections, because both parties pull the same levers, and play the same games. And we’re going to get the amped up rhetoric. The idea that we’re not going to build LNG export facilities is just nuts. It’s probably the most important lever we have for geopolitical policy. And we’ve held energy security over Europe’s head for decades. So that’s not going to change. So we are going to get amped up rhetoric. I think what’s important for the elections this year is really driven by the setup of the expiring tax cuts that expire at the end of 2025. I think if we end up in a gridlock, which is more than likely the case, then the path of least resistance will be that those tax cuts will expire. And that’s important. That’s a much higher corporate tax rate. Right?

Chris Wallis: And they could be important to risk assets moving forward. If we really have to deal with our fiscal deficits, and it becomes apparent that we’re going to have to, it may be the case that Congress says, “Look, we’re just going to let them expire. And we’re going to blame each other, blame the opposing party for it.” So I do think there’s a little bit more importance as it relates to the market. With this election, regardless of what anybody’s political views are, the corporate tax rate’s a pretty important element. And if we don’t do anything, maybe it moves higher. And at the same time, there’s a cap on the deductibility of interest as well. And we’re going to really start to see the ReFis pick up in ’24 and beyond. And if we don’t fix that, the cost of debt’s going to be much higher for a lot of companies. So in that sense, what happens at the elections in 2024 really is going to matter for stocks for sure.

Dan: All right. Good. Well, let’s wrap it up right there for today. So thank you Chris. Good to have you back. And we’ll see you soon.

Chris Wallis: Sounds good. Thanks Dan.

Dan: The views, information, and or opinions expressed during this podcast are solely those of the individuals involved, and do not necessarily represent those of Vaughan Nelson and its employees. Vaughan Nelson does not verify, and assumes no responsibility for the accuracy of any of the information contained in the podcast. The primary purpose of the information, opinions, and thoughts presented in this podcast is to educate and inform. This podcast, or any podcast in the series does not constitute professional investment advice or services. And any reliance on the information provided is done at your own risk. Past performance is not an indication of future performance. By accessing this podcast, you acknowledge that the entire contents of this podcast are the property of Vaughan Nelson, or used by Vaughan Nelson with permission, and are protected under US copyright and trademark laws. Securities discussed within this podcast may be held in the Vaughan Nelson strategies.

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