Chris Wallis, CEO and CIO at Vaughan Nelson, joins the podcast to discuss the continued market volatility, what is fueling the volatility, and indicators to monitor.

September 5th, 2024

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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 good to be here, Dan.

Dan: All right. Well, Chris, we’re seeing a whole bunch of market volatility again and it’s rampant. We’re starting to see some credit trades that’s in the market. Those continue to struggle. We’re seeing investors appear to be booking their gains. We’re starting to see them rotate into the laggards. Question here, to start off today, do you think that this current volatility, it’s discounting shift in fundamentals? And you think that’s going to become apparent over time? Or do you think that’s just what we’re expecting? This is just normal September volatility?

Chris Wallis: I think it’s more of the latter, and when I say that is there is the seasonality to September that has a lot to do with just natural flows and the volume in and around the options market. You should expect some volatility. You add to that that we came into this seasonally weak period with a very narrow market, very narrow performance, very crowded trades. And quite frankly a lot of short-term leverage and short-term option volume driving the market.

And so that should lead to some pretty violent rotations as that narrowness and that out of balance state of the market has to unwind itself. And we saw that begin really about the second week of July. And we call that the unwind of the yen carry trade. We’ve given it a lot of different names. And that would indicate to me that the market got out of balance and we need to unwind that.

At the same time where the market is getting data that says, “Look, growth is continuing to slow. That while the services side of the economy’s fine, the industrial side of the economy’s not re-accelerating. Inflation is coming in and a slowdown in growth and a slowdown or decline in inflation is very negative for equities in general.” And so that adds a little bit of volatility to the mix.

And we’re also getting data that now is confirming, “Hey, guess what? The first half of 2025 is going to continue to see further moderations in growth and probably further declines in inflation as well.” The market needs to back away some of the hope that was built in. You have a confluence of those factors as well.

And so could the market say, “Look, there’s a shift in fundamental”? Absolutely. And there’s things that we could monitor that would indicate that. Our leading economic data that leads the economy by nine to 12 month and is very good at pointing out recessionary conditions or pointing out just general slowdowns is saying, “We are going to continue to see moderating growth. This is not a recession that’s underway.” But we need to be mindful. We need to look at, look for other indicators that, hey, there may be something more to this than what would show up on just our economic data. Yeah.

Dan: It’s one thing you just said there, talking about shifting fundamentals and some things that you can monitor. What is it? What will you monitor, what you continue to monitor to confirm your view?

Chris Wallis: Yeah, look, we’re going to continue to monitor our leading economic indicators and just make sure that we’re not developing conditions that would lead to a recession. We need to be very cognisant of the coincident data. which is really the employment data, which is lagging, and some of the inflation data, which is lagging. And overlay what’s happening real time in industrial commodities that have been very weak. In the energy space, energy products are clearly experiencing very weak demand. China is still really suffering on the industrial side of the economy and just writ large. And that could demonstrate and come through as a very large deflationary shock, which changes a lot of things in the market.

The other thing that I think you got to realise is while we’re having a slowdown, this is the first time we’ve had a slowdown with sticky inflation. Inflationary pressures are coming down, but it’s sticky. We’re used to deflationary or rising disinflationary conditions that provide relief to companies and so they’re able to manage the margins. And that’s not playing through right now so that’s also creating problems out there.

And then we just need to watch market indicators. What is the fixed income market doing? What are currencies doing? We talked a lot about really earlier this year and late last year that the unwind of the yen carry trade, but the unwind of the yen as a borrowing currency could create a lot of friction in capital flows and friction in capital markets. And clearly we’re starting to see some of that. That’s something to continue to monitor.

The other thing I’m going to watch is just investor behavior. And I’ll give you an antidote and I’m using this as an example of real life conditions and what people are doing and why it may be nothing more than a rebalancing or maybe something even more significant, but we won’t know. We need more time to tell. Look at some of the moves that Berkshire’s been making and what it’s been making. He sold half his Apple position. He began selling his Bank of America position significantly in the second week of July and has been a steady seller despite weakness in the security. And he’s a very price sensitive individual. He’s likely going to generate some taxable gains and he’s loathe to pay taxes if he can avoid it.

And there’s no reason to think if there wasn’t something more difficult transpiring in the credit market that you could continue to compound Bank of America’s equity at high single, low double digits, which is clearly an acceptable return to him because he’s made plenty of investments with those underlying return characteristics. It just so happens that the unwind of Bank of America began about the same time that we saw the bottoming in the Japanese yen and the real friction development equity markets. Is it just indications of accumulation and raising cash?

He’s got pretty good intel into the broader economy. He’s got very good intel into monetary policy and into the financial system. Does he see something developing on the credit side of the equation where he wants to build cash? Or is it nothing more than rebalancing a portfolio and raising 100 or so billion dollars? Because who knows, maybe he wants to go buy a Disney or some other large asset out there.

But I do think it’s indicative of what’s going on. I think we’re in an environment where equities were extended and the trade was quite crowded. At the same time, market participants are starting to anticipate lower interest rates. We’re starting to see rising disinflationary and potentially deflationary conditions out of China. Why wouldn’t you sell some of your equities, lock in some gains, avoid potential higher tax increases in 25 and beyond, and move out in duration and buy some attractive fixed income? It could be something as simple as that.

This is a time when you need to watch what people do more so than what they say, watch the leading economic data. Don’t panic. Quite frankly, we’ve been looking for the drawdown in the equity market to add to positions to concentrate portfolios more. We believe inflation is going to continue to come in light for the next couple of months and then firm up a bit. And at the same time, GDP growth is going to slow into the fourth quarter and maybe stabilise a little bit before it slows again, not into recessionary conditions. It’s a chance to take advantage of some of this volatility that comes in the less liquid markets.

Dan: Well, Chris, I think that’s a good place to stop for today. Good chat catching up here and thanks for your thoughts and we’ll see you soon.

Chris Wallis: Sounds good.

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