Chris Wallis, CEO and CIO at Vaughan Nelson, reflects on the Fed’s willingness to tolerate higher inflation, tactical allocation, and asset classes to deemphasize.

March 21, 2024

Lightly edited transcript

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

Chris Wallis: Thanks, Dan.

Dan: All right, Chris. Well, I guess welcome back. It’s been a couple of weeks of travel for the both of us. We haven’t been able to have a chance to sit down, but in the meantime, yesterday we had a Fed meeting, and the Fed’s commentary indicated that their inflation view seems to be one where either inflation continues to decline or that the Fed is willing to tolerate higher inflation. First, I guess a two-part question here. One, where do you fall on this view? Then the second piece is do you think inflation is going to decline further, or is the Fed signaling that they’ll tolerate a higher sustained level of inflation?

Chris Wallis: Yeah. I think the takeaway from the Fed’s commentary, and even the actions they’ve been making in their supervision responsibilities with the banks, is that they’re more than happy to tolerate higher inflation. I think that the key point to remember is the Fed’s goal is no longer, or never was, to tolerate or accept higher levels of inflation, meaning they were going to prevent inflation from becoming rooted in the system, or to target employment. Their goal is to ensure that the U.S Treasury market remains highly liquid. With that, they probably are going to have to tolerate a little bit higher inflation and be prepared to step in accordingly.

It’s very clear over the last three months that inflation at a minimum is going to firm, but it’s likely going to start to increase as we get to the back half of the year. We’ve seen energy prices move up 20%. Gold’s hitting all-time highs, which is a clear signal that the market believes the Fed is going to allow inflation to remain higher. We’ve seen transportation costs move higher. We’re starting to see signs that we’re going to see further strength in housing, and all that ultimately is going to flow through to higher inflation.

The Fed knows they’re in a tight spot. They’re coordinating with the U.S Treasury. They’re making moves such that banks can continue to fund very high levels of deficits, which is just direct monetization of those deficits. Given it’ll be the banks that likely fund it, it’s going to add further inflationary pressure, so investors should be prepared for that. It doesn’t mean we get back to 8 or 9% inflation, but it does mean it’s not going to be 2%. Whether it’s 3, 3.5, 4, 4.5%, we will just have to wait and see, but it’s definitely going to become more embedded into investor psyche and also in employee psyche. It’s going to start to feed on itself over the next few years.

Dan: On our last podcast a couple of weeks ago, we touched on all-time highs, and here we are getting towards the end of March and the rally in the equity markets, it continues to broaden. That potentially might be signaling that we could be entering a period where we’re seeing accelerating economic growth and higher inflation. Do you think that investors should start considering making some tactical shifts? What I mean by this is do you think small caps, are they more attractive than large caps today? Do you think non-U.S. is the place to be versus U.S.? Where do you come down on those?

Chris Wallis: Look, I think in the end we’re going to see some moves, maybe small caps catch up with large caps in the U.S., over a short period of time. A lot of this has to do with positioning. We know for a fact economic activity is going to accelerate modestly beginning in Q2 of this year, not just in the U.S. but also in Europe. We also know, as we just discussed, that inflationary pressures are going to firm and potentially start to increase. That in combination means equities are going to be in a fairly positive environment, and it’s happening at a time when we’re seeing increased global liquidity specifically out of China, which would indicate, hey, we should start to see some strength in non-U.S. markets as well.

As an investor, let’s step back and think about when the broadest move and the largest move is made. The largest move in equity markets typically occurs when economic activity is very sluggish and there’s concerns in the market, and you have both strong fiscal and monetary support being pushed into the economy and being pushed into markets, in order to offset those concerns and those downward pressures. That was 2023. We saw a powerful rally in small caps in the fourth quarter and we’ve seen it continue modestly in the first quarter, but at the end of the day, we’ve seen leadership out of the large cap sector.

I think what we’re going to see now, and as an example, after the Fed’s press conference yesterday, we saw really strong moves out of small regional banks, really strong moves out of the most heavily shorted stocks. That reflects positioning. On the margin, coming into ’24, people were still positioned for further economic weakness and the chance of a recession occurring, and that window of opportunity is closing.

This initial move, you’re going to start to see people covering high short interest stocks, people selling some of their winners. Maybe we’ll see it out of some of the Lilys and the Novo Nordisks of the world where people have made a lot of money. Apple is going to have some headwinds because now they’re going to get sued by the DOJ. People are going to have excuses to sell some of these larger-cap or some of these prior winners, and the machines and the momentum and just general retail investors are going to start chasing these other themes.

I think it’s important to understand that the theme for 2024 and beyond is going to be that there is no theme. The idea that there are big pockets of valuation disparity in North America between large caps and small caps, or between North America and the rest of the world, is a myth. I think if you really get in and do the work and look at the valuation disparities, they’re very consistent with the underlying growth, the underlying level of return on assets and profitability and opportunity sets, and there is no big pocket of valuation opportunity.

Don’t go chase hard assets. Don’t go chase smalls versus large. If you have areas where you’re overweight and they’ve been strong winners, yeah, sure, take a little bit off, rebalance your portfolios, but there aren’t big tactical adjustments to be made. I think the biggest element to think through is passive has done incredibly well, and as we saw in ’22 and again in ’23, it started to struggle because there’s underlying rolling bear and bull markets across asset classes and sectors. That’s going to continue.

As we see inflation pick back up, that’s going to challenge bond proxies, that’s going to challenge companies that were starting to discount much larger rate cuts than were going to be available. Just know that. Allocate to areas without stretched valuations and kind of rebalance if you’re a little out of balance, but there are no big tactical shifts to be made across equity markets.

Dan: Maybe on the tail of what you’re just describing there, the inverse, right? Are there any asset classes out there that you would avoid or de-emphasize?

Chris Wallis: Yeah. Look, I am still not a big fan of fixed income and fixed income proxies. While we’ve seen rates move materially higher, I think credit spreads are fairly tight, and I think it’s for a lot of reasons, there’s just been a lot of liquidity produced in the world, and the market is attracted to those higher yields and it’s been moving there, so that’s put downward pressure on spreads. At the end of the day, look, inflation is going to move higher. I think the Fed has to engineer a steeper yield curve, and so they’re going to cut rates, which is going to add a little bit further pressure to inflation expectations.

Quite frankly, I just don’t think there’s a lot of cushion in yields today, especially in investment grade and even in high yield, that the spreads relative to the underlying Treasury curve are incredibly tight, and there’s just not a lot of room for error to the upside in inflation. Quite frankly, I think you’re going to make more money over the intermediate period of time in equities, so I would do that.

Look, the Fed I think is going to cut rates soon. I think the surprise cut out of the Swiss National Bank today is an indication that it is going to be a very coordinated rate cut environment. With the Swiss National Bank cutting rates, now the Fed can cut rates and it won’t put too much downward pressure on the dollar. As we’ve said, with everybody devaluing currencies, it’s going to be devalued against some goods, but also asset prices, and that is always going to benefit equities at the expense of fixed income.

Dan: All right, good. Well, a good one today. Thank you, Chris. We’ll wrap up there and we’ll see you soon.

Chris Wallis: Sounds good.

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