Chris Wallis, CEO and CIO at Vaughan Nelson, shares his view on the Fed cutting rates and what will drive a greater breadth in market leadership.

June 20th, 2024

Lightly edited transcript

Dan Hughes: 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: Okay, Chris. Well, we had some inflation data get released. We had the Fed meeting coming out and here we are, US interest rates, they have remained relatively stable.

We’ve seen that performance of the S&P 500, that continues to hit new highs. I think we’re running another one today. Very narrow market leadership has been brought along with it, so we’re starting to see some movement. The ECB, they joined in the rate cutting. We saw the Swiss Central Bank do the same.

Going back to some comments that you’ve made in some past podcasts, you mentioned that you expected inflation was going to start firming up from here. If that’s the case, do you still anticipate the Fed’s going to cut rates? If that’s the case, what’s the catalyst for the rate cut?

Chris: I think unfortunately the economic weakness is the catalyst for rate cuts may be behind us. We’re going to see continued weakness out of areas of the economy that are impacted by higher rates, so you’re going to see further deterioration in credit, you’re going to see deterioration in private credit, you’re going to continue to see weakness in housing and in commercial real estate, but you’re not going to see a big weakness on the services side of the economy. You’re not going to see big weakness, in fact, you’re going to start to see strength out of the industrial side of the economy. As you just mentioned, inflation is going to continue to firm up. By the fourth quarter, maybe moving as high as 4%. Unfortunately, I don’t think we’re going to get economic weakness as the catalyst for rate cut.

Do I think the Fed’s going to cut rates? Yes. I think they’re desperate to find an excuse to cut rates. I think they may move the goalpost on what they’re looking at in inflation to be able to do it. Maybe we’ll get some weak employment data and they’ll use that excuse in order to do it and then we’ll see, because they need a steeper yield curve.

They would love for it to be a steeper yield curve and a bull steepener with the curve shifting down, but I think for that to happen the rate cut will be further into the future because what’s going to drive that is really weakness in credit markets. Meaning we’re going to stay here long enough that the loans that have been modified, the hope that we would get rate cuts to save parts of the real estate market and save parts of credit don’t happen, which means the people that own this paper have to start marking it, and that would tighten up liquidity conditions and we would have weakness emanating out of the credit side of financial markets. That very much could be in the case.

I think they’re going to try to find an excuse. I think, quite frankly, if they did one or two cuts over the next, call it, three to four months into farming inflation, into modest improvements on the industrial side and some general softening elsewhere in the economy, but nothing really falling apart, that would put steepness in the curve. It would allow the long end of the curve to rise so much, which is negative for funding deficits because we’re going to see an increase in coupon issuance, but we do need a steep curve so that we can have collateral transformation in the financial system so that banks and other players can step up and buy some of these treasuries that are going to be issued to fund these deficits.

I very much think they’re going to cut rates. I think they may have to invent a reason or will create eventually tight enough liquidity conditions that will have losses in credit and real problems that may lead to layoffs. Right now, very much in the cards whether it’s one cut, two cuts, three cuts, we’ll see. They always have a clever way of making up a reason and excuse for what they do.

Dan: A couple cuts. Make some stuff up. Keep going.

Chris: Yep. Exactly. These are not the droids you’re looking for, Dan.

Dan: Exactly. How about just maybe around the lines of the performance that we’ve seen. We’ll just use the S&P as a proxy here, but really narrow leadership continues. What are we looking for now? We need to see some improvement in the market breadth.

Chris: Look, this is all a part of what I’m going to call the great rebalancing. This is a multi-year rebalancing we’ve talked about. You get a spurt of reflationary metrics, you have leadership out of the commodity space, and you look like you’re getting a little bit of increase in economic activity out of China. Then all of a sudden that rolls over and then you get a correction.

Normally what you would get in this environment would be not just movement higher in the AI related stocks, but secular growers more broadly, and that didn’t happen this time. The reason I don’t think it happened is I think the markets are going to bleed multiples. What I mean by that is if we’re going to keep interest rates at this level, and right now inflationary conditions would say you should, so the risk premium is going to remain more elevated than it would otherwise be and we’re going to see firming conditions. Then if you’re trading at 25, 30 times forward earnings, you better have accelerating growth. You better have margins that are set to improve.

If not, then, and if you report any weakness or any decrementals on the margin, meaning you can still beat earnings, but if it looks like the slowdown and margin compression may continue for a bit, you’re going to sell off. You’re going to sell off dramatically because I can always just go back and buy a short-term treasury at five and a quarter percent.

‘I think we’re going to keep bleeding multiples because participants are still positioned for an old narrative driven world and there’s just no question that AI has sucked capital out of the rest of the market, and the machines have desperate to find momentum, and it’s in AI right now. We’ll see how much longer that lasts.

Ultimately, it will snuff itself out. Either their narrative will start to… the myth around what’s really driving it will either be proven or disproven, or you’ll get too much capital involved in the trades. Either the momentum going into specific names or using the options market to propel the underlying stocks higher, but eventually you get so much capital in there that the trades stop working. When that stops working, it has to unwind itself. I think most of market participants anticipate, well, okay, well once it breaks down, it’s just going to go to the other parts of the market.
I don’t think that’s necessarily the case.

It could be it goes to cash, it goes to other asset classes. It will stop, when is anybody’s guess. But we’re not going to get more breadth in the market until we see broader re-acceleration in economic activity, broader increase in earnings expectations, and get back in line where the market’s expectations for an easing in financial conditions are consistent with the underlying fundamentals. We’ve been, over the last kind of four or five weeks, just been pricing in, quite frankly, a bare market. Take those six rate cuts, now we’re down to one and change. That creates a bare market unless you’re NVIDIA and their peers that are clearly winning all the incremental capital at this stage.

Dan: All right, good deal. Well, I think that’s a good place to wrap up for today. Thanks for coming on and we’ll see you soon.

Chris: Sounds good.

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