Investors: check yourself before you wreck yourself

In the latest episode of the Vaughan Nelson Podcast, CEO and CIO Chris Wallis discusses the hot topic of tariffs and how in this increasingly volatile geopolitical environment investors need to pay greater attention to their investments.

As tariffs become a focal point in economic discussions, Wallis argues they are not just revenue and negotiating tools but are intertwined with trade, currency, and geopolitical dynamics. He says the U.S. must rebalance its economy, confront its industrial decline, and navigate an evolving global landscape where hard power has now become much more important than soft power.

Chris argues that investors should stay nimble and understand how these new global dynamics might impact their investments, with investment fundamentals and valuations likely to be of paramount importance.

Podcast recorded on 27 February

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: All right, Chris, today we're going to take on the topic of tariffs. It's in the news. It's everywhere. It's President Trump's favorite word. And with that, first question, what extent are tariffs a negotiating tool versus just a way to raise some revenue and address the deficit?

Chris Wallis: Yeah, I think the way you need to think about tariffs is, of course, they're a negotiating tool, but don't think of them as they're not going to happen or they're not related to several other features. I think too many people look at tariffs in isolation and it's clear. So if you look at the full situation, we have to cut spending, we have to cut deficits, and so we do have to cut spending and we do have to raise taxes. And you're going to find this administration, and I think rightfully so, is focusing on ways to raise taxes on others and not the US population because what we're going to have to do is cut government spending and drive more investment out of the private sector where you get a larger multiplier and a greater return on the investment and the growth. 

Those are just all of those topics or opposite sides of the same coin. So when we talk about tariffs, it actually impacts the dollar and security guarantees. So all of these issues are woven together and you need to think about it that way. The other piece of this is we are going to have to rebalance trade. So go back post-World War II, the general mantra or what we did was, okay, we're going to build a currency system around the US dollar. We're going to open our economy to the rest of the world. We still have the lowest tariffs and the lowest barriers on the planet. Other countries, our friends can sell their goods into the US and rebuild their economies after World War II. And in exchange for that, they're going to trade global commodities and global goods and dollars and buy our treasuries. And so over time, it wasn't as big a deal early on because we were manufacturing as much as they were and traded goods were more in balance.

But over time, it morphed into a system of the US overconsuming and using the savings of other countries in order to fund that consumption. And it hollowed out our manufacturing sector and it hollowed out our middle class. And so we have to rebalance. And the normal mechanism for rebalance would be a weaker dollar, but that can't play out when we're the reserve currency. And the reason it has to rebalance is quite frankly, the rest of the world got so large relative to the US that we can no longer maintain that system. We're just too small from a consumptive standpoint. And more importantly, it hollowed out our industrial base. And now our enemies or our new enemies are waking up to the reality that China is an enemy. They can use that against us to knock us off in a unipolar world. So now we're in a multipolar world.

We've got to rebuild our industrial base. We've got to be able to secure our own pharmaceuticals and penicillin. We have to be able to make our own missiles. It's very clear that NATO lost the battle in Ukraine. We couldn't produce munitions fast enough. Russia outproduced us. And so this system is going to change and we got to recognize that. And so tariffs by themselves will be insufficient. So it's tariffs plus a weaker dollar, and then you can rebalance goods. How do you have a weaker dollar? You have to enter into different arrangements with your allies. So you're going to see spheres of influence change. You're going to see people scramble to get on one side or the other. And if there's not a choreographed or coordinated currency move lower for the dollar, it'll have to be done unilaterally. And that's why you hear people talking about, we'll just revalue gold and you can't have two different gold prices in the world.

So if the Fed or Treasury is buying gold at a specific rate, it'll get arbed away and that can weaken or strengthen the dollar. So all of that is going on currently. And what you're seeing geopolitically is a recognition that soft power is waning and hard power is now the most important element. And that's not new. That began in 2014 with the first invasion of Ukraine and then with the second invasion of Ukraine, it's kind of on steroids. It's just becoming aware because you have a US president who acknowledges it and is speaking truth to Europe and others. And you can also see it in how negotiations are playing out. Trump is not negotiating with Brussels. He could care less about the European experiment. He talks to countries individually in Europe. But this negotiation is going to be between Russia, the US and China. And right now they're trying to decide how they want to split up Europe, and Europe and Canada and others are scrambling around for relevance.

And so it's walking up to a checker's board and just kicking the table and all the pieces go flying. So that's essentially what's going on right now. I think what you'll see is the desire to get to a ceasefire in Ukraine and leave the security at the hands of Europe and leave the economic burden at the hands of Europe. And that's why we've seen UK in the last 48 hours talk about putting boots on the ground and everybody's kind of changing their tune because I think the US is going to pivot towards the Indo-Pacific and start moving military assets that way because that's probably where things are going to heat up next. So tariffs are not a single issue. They're tied to all of these elements and all of it is going to slowly start to matter across time and space.

Dan: And so let's think about this from an investing perspective now. So how are companies responding to that situation? Ran through an awful lot, but what are you seeing out there as you're speaking with management teams and taking a look at businesses?

Chris Wallis: Yeah, so as I said, this impacts flows of funds. At the end of the day, if you're going to have a trade war and that changes where goods flow, then what follows that is a currency war because the currencies and the monetary flows follows the goods. And you can imagine if you're a manufacturer or you're a company and you're looking at what's going on, you're going, "Hey, I don't know if I'm going to have zero tariffs or if they're going up by 25%. I don't know if I'm going to be sanctioned, if I do this business. If I'm going to reshort, should I go to Mexico or do I have to come all the way into the United States? 

And so what we are seeing in the data is the services side of the equation looks like it's slowing down. This is nothing dramatic, but things are slowing. The bond market is screaming at you that things are slowing. It's starting to price in some rate cuts. Ironically, we're getting underlying impulse of strength in the industrial side of the economy globally and in the US. And that's just, we've exhausted inventories, but until we get some resolution and we start to see money start to flow again, then that may be somewhat of a nascent recovery. And the other part of this is what's going on with Doge? Look, we need to cut 400 billion plus of spending. That could easily be 1.5, 2% real GDP decline. So you're going to see this tug of war between a slowing of federal spending and the direct impact that's going to have on the economy, which can be quite significant. And then trying to create the incentive in the acceleration in the private sector.

So we slow federal spending. We cut a deal with countries in Europe and with Japan to accelerate export of LNG and speed up some of our energy exports. And there's a lot of infrastructure that needs to be invested in within the US and you're going to see kind of this push-pull in that regards, but it's going to create some air pockets here and there. And we're starting to see that at the company level.

Dan: And so wrap this up in light of everything that you described today, what actions do you think investors should start taking, if any at all?

Chris Wallis: Look, investors need to... I think the most important thing to understand is don't get caught flat-footed by lack of imagination. We're going to see the lines on countries move. And when you see lines on countries move, or when you see spheres of influence move, then you're going to start to see your price charts on your favorite risk assets start to move as well. So that volatility is going to follow.

The market's done a pretty good job of understanding this. The relative performance in the market is driven by the fundamentals and driven by these underlying conditions. So just because the narratives are catching up, the market is very aware of this. So the relative positioning and the relative performance of assets already reflects everything I'm saying. However, there's been a buoyancy to the market that has been driven by liquidity and what I'm describing as a world where liquidity may flow differently.

So if less money flows into US risk assets, that may be some multiple contraction that may increase the equity risk premium and things such as that. So I think the most important thing for investors to do is check your valuations. That's what we're doing with our portfolios. When you're getting it at these points of inflections, don't just own something because it worked. Does it make sense that a Walmart trades at 37 times forward earnings? Maybe it does, maybe it doesn't. But you need to understand why. And you need to understand where those valuations are.

Because over the short term, if liquidity tightens up, which we know it is, and if equity risk premiums change or capital is less plentiful, that's when valuations start to matter. And so you can look at your fundamentals, understand your valuations, and if you're comfortable, there's really not much to do.

And then other than that is just be very aware of what's going on. And again, just don't let failure of imagination catch yourself flat-footed. We're moving into the world the way it used to be.

And just to highlight how fast this is moving, we've already gone down and are starting to kick China out of the Panama Canal. This talk around Greenland is not isolated. It's going to come true. And the reason is Canada is relevant in a hard power world, but control around the Arctic is, and right now, China and Russia have a lot of influence, and the US isn't going to let that happen. So Canada and Denmark can come along with us or we'll step on them on the way, but that's going to be a sphere of influence for us. And you'll see it play out. You'll see it play out through South America and elsewhere. So it's going to be fun for sure.

Dan: All right, first ever ice cube reference here on the podcast. Nice work here. All right. And that's a wrap for today. Thank you very much, Chris, and we'll see you soon.