Is the Federal Reserve's greatest challenge still coming?

No one likes hearing the "I" word (inflation) or the "R" word (recession) more than they already do. Both words have been the key themes for markets to grapple with in 2022. But what really matters more in these times? If the COVID-19 pandemic has proven anything, it's that every adage about the issues that fundamentally shift markets has been tested significantly. Nowhere is this more apparent than at the corner of Constitution Avenue and 20th Street NW in Washington DC, also known as the headquarters of the Federal Reserve. 

In this Expert Insights, we're going to look at the shift from the old order of investing to this new, more challenging era with Chris Wallis, CIO at Vaughan Nelson Investment Management. 

Wallis will share his views on what the Federal Reserve's next challenge may be, and how its response could dramatically affect your returns. As a bonus, he'll share with you why he is choosing to deploy his cash now into very select stocks.

Don't be caught out in what Wallis calls "treacherous waters" - watch the video or read our edited transcript to get ahead of the game. 

EDITED TRANSCRIPT

LW: What is the bigger risk right now? Inflation or recession?

Chris Wallis: Markets face several risks right now. The two probably biggest risks out there are whether we can contain inflation or whether we're going to deal with a recession. Earlier in the year, it was primarily the inflationary pressures, but the markets already recognised that we're seeing disinflation in goods. And while its move to services is actually trending in the right direction. If you look at bond markets, it's very clear, they're more concerned about economic growth and quickly we're going to be pricing in an industrial recession globally. And so that shift to the focus on recession is imminent. Inflation may come back into focus as we move into early 2023 if we don't see a continued downward trajectory in those inflationary pressures.

LW: Can the US Federal Reserve fight inflation without killing growth?

Chris Wallis: If I was at the US Fed, and you really think about the challenge in front of them and they've kind of got to look at both inflation and economic growth, they're in a tough spot. The traditional goal of 2% real growth, 2% inflation really isn't achievable from here. And quite frankly, they have a bigger issue, which is the sovereign government cannot be financed at 3% inflation. They have to get interest rates lower. 

So can they really raise rates sufficiently high to quell inflation, or will they be forced to pin the yield curve lower at 2% and restart QE?

A lot of that's going to be dictated by how quick the economy slows down, and how much damage has been done to the credit markets. And do they need to weaponize the dollar to help fight some of the geopolitical pressures that are developing? They're in a very difficult spot, even beyond inflation and the need to quell those pressures.

LW: What are the best ways to preserve capital in today's market?

Chris Wallis: Inflation is really the enemy of capital. And we need to understand from history and be realistic about what we're dealing with. We've always closed the wealth gap by destroying the wealth. If you're an investor and you're using the wins of the last 10 years, you're in real trouble. You need to really focus on not just sectors. You can't go out and say, "Oh, inflation's coming. I need to own more energy companies." You need to own the right energy company. You can't say we're going to spend money in renewables so I can go get that, no. You need to own the right distributor. 

You have to find companies that can pass through these cost pressures, but yet their valuation already reflects the fact that we're going to have higher inflation, higher cost of capital, which means lower multiples. 

Otherwise, if you just go and buy your favourite company, go buy your favourite big cap, buy your favourite consumer staple. You may be right. They may build their earnings. They may keep those earnings in inflation, but you're going to give it back up in multiple. 

It's a really treacherous environment for your average investor. And it's a difficult environment to invest in.

Also, inflation means more volatility. Use it to your advantage. Don't chase. Play the market like a backboard, let your opportunities come to you and then strike when the time is right. 

LW: What do you need to see in markets to become more aggressive?

Chris Wallis: So as we look at the challenges that are developing for the market from a larger standpoint, some of the dislocations we're probably going to have in credit markets over the next 12 months. It's important to understand why we talk about these big macro factors. In the real world market, it knows this. 

You've had sectors that have been selling off for a year now. Some for even 18 months, those early stage cycles that recognise the slowdown were hit by liquidity earlier on. Those opportunities are developing just as the market's starting to recognise.

Well, guess what? The market's a discounting mechanism. You need to be deploying that capital six months before the data starts to get better because the market's already bottoming. While we're talking about the challenges in front of us, recognise we've already prepared for those. We've already preserved that alpha from the prior year. 

What we're looking to do for the next several quarters is - let's redeploy that cash that we have in the balance sheet. More importantly, the positions that have worked really well, despite the challenging environment where everybody's still hiding out, start booking those gains. Already, start redeploying out. 

It doesn't mean they're going to do well. They're just going to go down last. You don't want to be the person holding them when they do.

Small caps for big thinkers

Vaughan Nelson recently launched Australia’s only global active SMID cap ETF (ASX: VNGS) to give investors access to their best ideas in global small-mid caps. Learn more here.