Lightly edited transcript
Louise Watson: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers where we bring you insights from our global collective of experts to help you make better investment decisions. I'm Louise Watson, and today I'm joined by Chris Wallis.
Chris is the CEO and CIO of Vaughan Nelson, a US $18 billion investment manager based in Houston, Texas. And he is also a senior portfolio manager on many of the firm's equity strategies. As well as closely following the stock market, Chris also keenly follows the global economy and he provides some of the most insightful and entertaining macro commentary I've ever heard. For anyone that would like regular insights on the US and global economy, I'd recommend taking a listen to the Vaughan Nelson Investment Management podcast.
Now, Chris has been a regular visitor to Australia ever since he launched the Vaughan Nelson Global Equity small- to mid-cap equity strategy here for retail and wholesale investors back in June of 2022, and he'll be back again at the end of April. Chris, thank you for taking some time out to chat to me.
Chris Wallis: Looking forward to it, Louise.
Louise: Last time you were here on the podcast, we had a great chat about books. So this is one for book lovers and book clubbers, and I know you are an avid reader. What have you read lately and what can you recommend to us?
Chris: I tell you, Louise, it's an interesting time in my book-reading right now, I'm kind of going back and touching base in a lot of ways, which is not a bad thing in a world where we seem to be hitting a lot of global resets.
So I'm actually reading three books right now. The first one is called Living Fearless: Exchanging the Lies of the World for the Liberating Truth of God, which is written by Jamie Winship. As you move through life, you gather baggage and it's a great way to kind hit the reset button for yourself personally.
I'm also going back and rereading The (Mis)behaviour of markets by Mandelbrot. As we know a lot of the economic theories out there and a lot of the asset pricing theories out there use a normal distribution or some various form of that. But when you really think about it, markets are fractal and nonlinear and we definitely witnessed that today after the implementation of Trump's tariffs.
And then finally, I'm reading No Trade is Free by Robert Lighthizer, just so I have maybe an inside baseball view of how the administration's thinking about the trade-offs as they go into these bilateral negotiations.
Louise: That's so great. I'm sure our listeners will love getting into some of those books and we'll give you some feedback on how we go. But I loved your comment there about the nonlinear market action that we've seen recently, and we've seen a change in global equity markets in the past couple of months. International markets have beaten US indices so far this year. What are the key factors which have driven that move and do you see this continuing?
Chris: Yeah. Louise, I really think this is a part of the great rebalancing that began at the end of '21 and we believe it's going to continue. What I mean by that is we're changing the flow of goods. We're changing the drivers of economies locally, meaning countries like the US that's used to overconsuming and using foreign capital to do so and have that foreign capital recycled back into their assets, meaning Nvidia and US Treasuries and everything else is going to reverse and go the other way.
And similarly, other countries that have been overinvesting and taking their excess savings and sending those to the US are going to start to keep that capital home. And I think what we've seen year to date is really inning one of that, which is nothing more than saying, "We've seen the stress that built up in the UK. They've said you need to keep more of the capital home to hold their pensions. You need to keep 5% to invest locally." They're now saying 10%.
We've seen similar hints out of Japan, but in general, the rest of the world is going to start running higher deficits. And when I say rest of the world, I'm talking about the developed world and the US is going to bring their deficits down. So that's negative for the dollar. It's negative for nominal US GDP growth, lower inflation, lower growth, which is a positive for rebalancing where the US has been, but it's pro rest of world's currencies.
And so I think we're still at the early stages of this and you can definitely justify it from a valuation and fundamental basis if we start to see European countries run higher deficits and start to see that rebalancing. I want to stress it may not be, quote, "today's leadership," but it will not surprise me if rest of world does better than US from a risk asset standpoint.
Louise: Interesting. As we move through this great rebalancing, the noise around US president Donald Trump will continue. How are you factoring in President Trump to your investment decision-making if you are, and what would you advise investors to do?
Chris: This is the way I think about Trump and his policies. I think the number one thing, as we talk about tariffs and we talk about rebalancing trade, I would really stress to people: ignore what you see economists write, ignore what you see popular news write and Wall Street write because they're going to come out with either a flawed model or they're going to come out really expressing their views based on their own interests.
And what do I mean by that? I would look at most of the economic commentary from a framework, an economic framework that really is out of touch with reality, not unlike capital asset pricing models or the Black-Scholes model. It's a great framework, but the assumptions only exist in the classroom and the textbook. When you get into the real world, you can use it as a framework, but you can't use it as a hard and fast rule.
Most economists aren't focused on the limiting constraints, meaning - do we have scarce resources? Yes, of course we do. Most economic models don't factor in the role of money and the availability of credit. They don't factor in, "Hey, as a country we have geostrategic interests that far outweigh, quote, "maximizing" the economic pie.
So for the US, can we or do we rely on, potential political and geopolitical enemies to produce our arms, to produce and replace our navy, which we're in the middle of doing and can't do, to secure key raw materials or commodities, right, to maintain security around IT infrastructure, to produce medicines - all of these things we have real interest in?
And for the US, quite frankly, we just got to the point where we were going to have to make some real changes. Now from Trump's point of view, and what that meant for the US is we have to raise taxes and cut federal spending. In Trump's view, that's a tariff. A tariff is nothing more than a tax.
So implementing tariffs around the world and having DOGE cut, quote, "wasteful spending" is nothing more than cutting federal spending and increasing taxes. And so if you look at that, it was going to happen anyway. We can either do it with a plan or we could have done it by just raising taxes on everybody inside of the US and then just cutting federal spending across the board. This was going to happen. This is not something that should have surprised anyone whatsoever.
Now we were kind of positioned in thinking, "Hey, we're going to raise taxes and cut federal spending." Trump gets elected, we go, "Okay, now we know we're going to do it through shutting down whole departments and we're going to do it through tariffs, which is fine. It's all the same net effect." It doesn't matter how the tariffs were calculated, it's completely irrelevant. The point is they're trying to raise a half a billion in taxes, 2% of GDP, that's what they put on in tariffs and they're going to cut federal spending.
The way we're thinking about it is coming into the year, we were already positioned for a market that was very low on liquidity, and we still are, that the US was going to experience a significant slowing in services, which it is. And the rest of the world was going to experience a reacceleration in industrial activity, which it is, which also supports what we've seen quarter to date, a selloff in US assets and a recovery in rest of the world, right? So it was right in line with those fundamentals.
I want to stress up until April 3rd, the selloff had nothing to do with tariffs. In the US, Q1 earnings are going to be somewhat weak. In Q2, they're going to be a little weaker, not off dramatically just lower growth. And then we'll start to see a recovery in the back half of the year.
So I think investors, they need to understand the game that's being played right now. They need to put their textbook economic hat away and don't get caught with the failure of imagination and understand that spheres of influence, trading spheres are going to change. And you need to understand who the allies are and who they're not, and then position accordingly.
It's not going to be any more complicated or any different than it has been historically. You're still trying to skate where the puck is going. You just got to understand there's geostrategic initiatives that are going to drive capital in different parts of the world.
Louise: Okay. Let's look a little deeper at how we play this game then and at portfolio positioning. And when you say rest of world, which geographical areas are you finding the best opportunities in right now? And how are your international strategies weighted?
Chris: Yeah, sure. And this is going to surprise a lot of people because I'm going to probably speak about countries that you wouldn't think we'd be overweight. So let's talk about what we don't own.
We don't own a lot of or any India directly, right? Great long-term outlook. But from an economic standpoint, growth has already turned down. We think they may have issues in the banks simply because they had such a good run for so long and they grew those loan books so much that when you get these kind of downturns, you can have some issues there.
While we have more Europe than we typically do, we're almost or we may be somewhat equal weight, which is very unusual for our non-US strategies, it's not, quote, in "ReArm Europe," right? ReArm Europe, if you're investing based on a narrative and you've made money, sell it, book your profits and move on.
And I think Europe is going to start to somewhat splinter geopolitically because their interests aren't aligned. There's very different interests in the Baltics, versus the core, versus some of the periphery. So you're going to see real fracturing there, but there's great opportunity there. There's no question about that. I got a better chance of playing in an NBA playoff than I think the European defence stocks have of driving earnings sufficient to justify the move in the stock price, right?
Areas that we have more exposure to than we typically do, South America, right? They've really been hurt by the strong dollar and the high US interest rates. They've been starved for capital. Our thesis coming into the quarter was: the moves we make are going to lower the dollar. We came in thinking we're going to cut rates fairly significantly. We still think that's the case. That's going to be a big relief for areas such as Brazil or even in Argentina, even Indonesia. There's some unique opportunities there as well for somewhat similar reasons and some regulatory.
But again, you're going to find... And this is all a part of this great rebalancing, you're not going to be able to target a specific country. And I'll give you an example. We've done well in Japan, right? But we are positioned for the Yen to rally. We're not positioned for the Yen to sell off and benefit the exporters, right? A lot of people went there for the export trade. That's not what we've done.
In China, when we look at China's positioning, we kind of view this rally they've had as a dead cat bounce. We don't think they're really stimulating sufficiently to rebalance the economy. We don't think they're providing sufficient relief to the banking system. So we would sell that rally, that dead cat bounce.
But what we are going to own in China are those that benefit from the move to local investing, the ramp up in key industries. So think semiconductors, right? They're building up a great semiconductor and memory business.
And what we're avoiding are the companies that have to compete with the Chinese manufacturers. I really think the market under appreciates how robust the Chinese manufacturing ecosystem is, how quickly they can do product development. And that provides a real structural cost advantage. And we're seeing that play out in the auto space writ large. You do not want to compete with BYD anywhere.
So China's interesting, not as a country, not as a broad allocation, but there's good rifle shots and we think that's going to be the case across the globe for the foreseeable future.
Louise: Yeah, locking in profits from the long ‘Arm Europe’ trade has been dominating the rhetoric here in Australia and other countries. And I really like that view of selling the dead cat bounce and taking rifle shots in China.
But the other thing that is still dominating our headlines and news flow here in Australia is still on the Mag 7. As well as an overall drop in US equities, we've seen some of the market darlings of the Mag 7 and other highly-priced tech and AI related names get sold off in the past. How do you see this playing out over the remainder of 2025 and beyond for investors?
Chris: Yeah. So the Mag 7 are in a unique position as it relates to this sell off because I could talk about their underlying fundamentals and I could talk about their valuations, but I think over the short term, that's really not going to drive the price performance.
What's going to drive the price performance is we're going through what I call a mini recession, not from an economic standpoint, but we're squeezing the excesses out of capital markets. What is the dominant excess really since 2012? And since 2012, it's US stocks, it's US large cap stocks.
Some of it's supported by the move to passive, but for the most part it's because the US has been running extraordinarily high deficits. That's led to higher nominal growth. That higher nominal growth has had higher earnings, higher earnings growth, better stock performance. And that's crowded in capital from all over the world into that deep liquid market.
And it went on steroids post-Covid because we massively overstimulated our economy and when we consume the rest of the world's goods, they recycled it right back into Apple, Nvidia and everything that we know about. And so when investors start to move capital home, they got to sell what they own. And so they're selling the Mag 7 and that makes a lot of sense to me.
And as it relates to the AI and data center trade, look, from a rate of change standpoint, the big initial move’s happened. I'm always a bit of a cynic. So I think there's two things going on right now:
- One, we need to see how much excess capacity we need.
- Two, we got to figure out how bad we really do need the NVIDIA chips or can we use other substitutes?
My own personal view is that the initial impetus for the AI trade, because it was a little suspect to me the way it was all coincidental, I think Microsoft saw an opportunity to go after Google’s search business with the latest developments within AI. They put in a big investment into ChatGPT and did that. The rest of the Mag 7, Meta and Google and Amazon saw what was going on, didn't want to get left behind, and would also love to disintermediate Google search business. And that was the big initial ramp.
The beneficiaries of all that spending was Nvidia and Taiwan Semiconductor. Nvidia is an incredible tech company. They have incredible development capabilities and software stack. They are also very good salespeople. So, they're as good at selling stock as they are at selling product and chips. And so they built a narrative around that and they're going to run with that.
And so now we've kind of hit this air pocket in that narrative, because Deepseek has said, "Hey, if all you're going to do is curated search, I got something that'll do that cheaper." And large language models aren't that special. And we've seen the more conservative of the Mag 7 kind of pullback, and that's Microsoft.
I don't think it's the end of, quote, "the AI trade" or anything like that, but we're going to go through a digestion period. So look, there's a lot of consternation and fear, but just remember that's how news organizations get clicks. Just try to keep everything in perspective.
Louise: Clicks and Jensen Huang's leather jacket seems to have had quite an impact on the market. But looking at the AI theme and your portfolio, and we've heard a lot about AI as being a theme that is lifting many boats and the downstream impacts of AI, do you have any exposure to the AI thematic in the portfolio and how has it impacted those stocks so far?
Chris: Yeah, relatively minimal. And the reason I say that is we kind of build our process in and around understanding cycles and industries and capital allocation. So that allowed us to stay out of autos and stay out of renewables over the last couple of years, which has worked well.
And similarly, that work would tell you, "Hey, the tech industry massively over-invested over a short period of time. From a rate of change basis, it's not going to get any better for the next 12 months."
So we've been selling into strength within the quote, "AI trade," the picks and shovels and everything else really for the last nine months. And while... I still lead our US small-cap as well, so I'm more familiar with the weightings there.
By Q1 of this year tech was our lowest weighting. It was sub 3% of the portfolio. Now that correction began in earnest in just the last four weeks. And some of these picks and shovels component suppliers are down 30% plus, some down as much as 20% today. So don't tell anybody, but we started putting some of those positions back on.
So look, as long as you understand that these are gross cyclicals and when everybody wants them, you need to sell them and take their cash. And then when nobody wants them, you need to give them cash and take their shares. And that's all we're trying to do. And so we would be... After this fell off really down in that small-mid-range, we would start looking to build those positions back here.
Louise: One of the strategies which we've seen largest interest from is the global small to mid-cap strategy or what we've nicknamed global SMIDs. For those investors that aren't as familiar with this asset class, can you tell us a little bit about the benefits of investing in global SMIDs versus the large cap universe?
Chris: Yeah, sure. Look, I think one of the biggest advantages, and you can just look historically at the results, these are not necessarily, quote, "small companies," right? They have the moniker, small-mid, but you're talking about an upper market cap range of US $40-50 billion. And we typically aren't going to go much below US$2 billion US. And so these are established businesses. There's nothing speculative in this space.
It's a very high ROA (return on assets) universe. And what I mean by that is high single digit ROAs, very profitable businesses can self-fund their own growth. More importantly, you don't get the SOEs, you don't get the big state-owned enterprises in here. You don't get the large financials that have accumulated a lot of bad paper in here. You don't get large businesses that can't reinvest and grow in here. You're really getting kind of the future leaders and it's borne out in the data.
So certainly from a volatility standpoint, the volatility and the returns are more attractive than what's existed in the large cap developed non-US space really for the last decade plus. I like it a lot.
I've been doing this for a quarter-century, and when I look at that universe, it reminds me a whole lot of what US small-mids look like in the early 2000s. And what I mean by that: high quality universe, good opportunities to redeploy capital and grow, very reasonable valuations.
So personally, those global SMIDs, that's my highest personal allocation among all our funds. And it's been that way since inception and I continue to find it very attractive. For a US investor, it's a great way to get exposure to the rest of the world. And for anybody who has too much local exposure, which in the US, every US investor does, they need exposure to the rest of the world, I think it's a very efficient way to do it. So I'm a big fan. I'm eating my own cooking.
Louise: I think your cooking's great, Chris. Are there any risks you are seeing in markets that you think investors aren't taking seriously enough?
Chris: Look, I think there's two. And one, there's really nothing investors can do about it. And that's the risk of passive. So passive has become the Frankenstein in the US and it's going to create distortions and it's going to have some real blowback because we're going to wake up one day and there's going to be an accident in the market. There's nothing you can do about it. Regulators are going to be a day late and a dollar short. They're all very aware of it. But at the end of the day, it's just a very inelastic market because those shares have been taken off the market. So my advice to investors is when that event happens, don't panic. It's going to be okay and don't read too much into it.
But the one thing that investors really need to understand is when you change trade flows, when you change the way goods flow, by definition, you're changing the way capital flows. And you need to understand that. And so you go through these periods in history where countries are viewed as exceptional. We saw that in Japan for a long period of time. We've seen it in periphery Asia, we saw it in China, and now we've seen it in the US.
What we're really saying is that country attracted an excessive amount of capital at below market rates, and they were able to take that capital and create asset bubbles or economic bubbles in activity. And I don't think the US is any different.
As I mentioned earlier, we've been crowding dollars in from all over the world. It's to the point where 66% of our GDP is held by foreigners in our assets. So as I mentioned, we've just been consuming everybody else's goods. They've bought all our assets, so we're hollowing out the wealth of the country. That's why it's all going to set to reverse.
So I think people need to be very aware of when they're investing in individual entities, did this entity benefit or was it hurt because of the way capital was flowing? Because it's going to reverse.
And unfortunately, I do think we're going to get capital controls. I don't see any way around it, and that's going to have an impact on market. So just be cognisant of that or find someone who is cognisant of that when you're seeking out investment advice.
Louise: And finally, it's been really difficult for active equity managers to beat their benchmarks over the past 10 years. Do you see this trend continuing or do you think active managers are better positioned in this current macroeconomic environment?
Chris: Look, I definitely think it's very much a market that's suitable for active management. I think the difficulty the last 10 years has really been in US large cap, which is just to say that's where all the dollars flowed, and that's where the big passive adoption was. Ex that; you could still generate alpha as you went down cap or across the rest of the world.
And where people struggled was just not recognising the significant impairment in assets, be it European financials, Chinese property, things such as that, right? And so I've always been a believer that macro is important and you would need to understand what trends can be sustained and which ones are reversing. And if you have that situational and contextual awareness, you can generate alpha in just about any environment.
But we're moving into an environment where volatility is going to be your friend and active managers should be able to take advantage of it. You use the volatility like a backboard in basketball, right? You play against it.
As everybody else is panicking, give them some cash. And if they want my shares at too high a price, I'll give them those too, right? So I think we're very much in an environment that's suitable for active management. So I'm pretty happy, I'm having fun again.
Louise: Thank you, Chris. It is so useful to get your insights into markets and the global economy at a time of such incredible change. And I'm heading straight out now to get my copy of Living Fearless.
Chris: Excellent.
Louise: If you enjoyed the podcast, please click follow on your favorite podcast platform to be notified of future episodes, and also check out the Vaughan Nelson Investment Management podcast. We have added a link in the notes, and of course, tune in again to hear more from our global collective of experts.
