Early Pull Back, 2024 Key Issues, 2% Target

January 4, 2024

Lightly edited transcript

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

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

Dan: All right, Chris. A couple weeks off, turn the page on the calendar, stepping into 2024 and I think the first thing we need to do is just a quick look back at 2023. A really incredible run from the markets. But then as we walk into 2024, typically January is met with pretty strong seasonal liquidity and I know we’re only in the first week so far, but are you surprised to see that the market’s pulled back over these first few days?

Chris Wallis: Yeah. I guess I’m not surprised to see them pull back. I think we had a lot of delayed selling that would’ve occurred last year, but why not defer your tax gains until the new year? And so I think that’s what we’re witnessing early on. And look, the rally in the fourth quarter was driven by flows and repositioning and what I mean by that is we got further information that the inflationary pressures were abating the increase in disinflationary pressures and then you got basically the Fed confirming that and acknowledging that, hey, as fast as inflation’s coming down, real rates are moving up dramatically, and since we may need to cut rates. And cutting rates heals a lot of issues that existed in the marketplace.

So for your growth stocks, it means that multiples can expand so your longer duration assets can rally. It meant your levered companies, your high beta, high cyclical companies may have a lower probability of refinancing risk, and it also meant that where you had asset impairments from marks and security books within the banks and the insurance space and elsewhere, that pressure was relieved as well. And what we were able to do in the fourth quarter then is ease financial conditions dramatically, while at the same time not bringing down growth estimates or earnings estimates on a go forward basis. And so you put those conditions together and you get a pretty powerful rally as people reposition to that new reality.

What it does mean is then clearly we’ve pulled returns forward. I mean we’ve got to acknowledge that, and so it sets up a very interesting, I think, 2024, and one that will, I think … may surprise people how it plays out.

Dan: Yeah, and I guess that’s really to the next question. It’s a bit of a broad one, but if we are thinking about 2024, and again, only in the first week here, but how do you see it playing out? What do you think will develop? Any really key issues that stand out in your mind to keep an eye out for?

Chris Wallis Yeah. Look, I think we’re going to see fairly weak economic data and earnings data in the first quarter, and it’ll probably start showing up with the data in December. And so we’re going to continue to see this weakening data out of the US for the first half may be too long, but certainly the first quarter and potentially into portions of the second quarter. And then we’re going to start to see stability, and we should start to see stability and economic growth, and stability and outlook as we move through Q2 into Q3 at the same time that I would suspect the US Treasury will have re-liquified its checking account and be pumping money and liquidity into the system to drive fairly strong growth going into the election. They’re not going to want that weakness to show up in the election.

I also think that by the time we get mid-year, we’re going to start to see stability and economic activity within Europe. And that’s going to be … That may surprise people, because as we all know, Europe’s been incredibly weak, but we’re already starting to see our leading indicators show that growth is going to pick up in Europe, and China has been obviously injecting a lot of liquidity into the system and we should start to see some improvement in China as well.

And so that means first half of the year we may be bringing down earnings estimates, and we’ve already pulled forward returns and expanded multiples and we’ve brought down rate cut expectations fairly dramatically. We may have to reprice some of that as we move through the year, but I think the real key for 2024 is going to be inflation. We’re seeing outright deflation in China, but we’re actually seeing the signals that inflation is bottoming in the rest of the world. So I think for the first half of the year there’s going to be this tug of war between economic weakness reaching its apex, and then deflationary pressures emanating out of China with a wall of liquidity and inflationary pressures building elsewhere. And so it may be difficult to get close to that fed 2% target, and so the market needs to be very careful about how many rate cuts are priced in before we see the weakness, or before we get confirmation that inflation really is going to reach those lower levels sought by the Fed.

And when you’re talking about rates and inflation, and we’ve already seen a material move lower in rates, this is where you get volatility. Because should rates move up 150 basis points or down 150 basis points, really has a big impact on valuations today we’re sitting in the 10 years right around 4%, so that’s a matter of going back to five and a half, or sufficient economic weakness that they break below three, and those are just two very different economic outcomes. So I think it’s going to be fun. It’s going to be a fun ’24 as we look and see how it plays out.

And as we know, not unlike the last couple of years, geopolitics stands to have a big influence as well. And I really think the results, the ultimate outcome for ’24 is because we are going to see this weakness in the first half and strength in the second. The real returns for 24 will be driven by the ’25 outlook, meaning we’re going to need to get into the second half of ’24, see if inflation is contained or if it’s picking up again, and then what those ramifications are, and then post-election what the ramifications are because we have a whole host of tax rates set to expire in 2025 that again will have a material impact on valuations and earnings.

Dan: Maybe one more for you then. Just thinking about all the volatility that you just described. How realistic is a fed 2% target? We’ve been talking about this for a long time. Do you think we can settle back in at that level? Do you think it’s going to be sustained?

Chris Wallis: I don’t know. We really don’t know, because every indication would be that the Fed’s going to blink and boost liquidity. They did it with the banking crisis when they didn’t have to. They’re already talking about pivoting, and it’s clear that the leading indicators of inflation have stabilized and are starting to increase.

We really haven’t seen sufficient weakness in owner’s equivalent rent to bring inflation further down. There’s a big lagged effect that’s going to roll through over the next six to nine months, and it’s going to put downward pressure, but probably not enough to get to the 2%, and yet the Fed’s almost declaring victory already. So that starts to sound political, or it starts to sound like they know that they need to get rates low enough such that we can roll the debt and not have a real deficit funding issue.

So I am reasonably skeptical that if we get to the 2% we can stay there. When you just look at the structural deficit spending, that ultimately is going to prove to be inflationary. So I’ll be surprised if we can get there.

Dan: All right, let’s wrap it up there then. Thank you, Chris. Next week we’ll be coming out with all of our fourth quarter strategy recap podcast, so keep an eye out for those. And Chris, we’ll get you back on here soon.

Chris Wallis: Sounds good.

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