This is a lightly edited transcript from the podcast
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. First macro podcast of the year here in 2026, and seemingly a good amount to talk about. We finally have Trump's pick for the Federal Chair. We're seeing that with Kevin Warsh. We're seeing some of the market narrative that's looking like Mr Warsh is a more hawkish pick. He was never quite a fan of quantitative easing (QE). He seems to have a strong desire to shrink the Federal Reserve's balance sheet. What’s your view of Kevin Warsh, and do you think this pick eliminates the fear of the Federal Reserve losing its independence?
Chris: Yeah. So let me separate it into two pieces. One, let's talk about the Fed's independence, and let's talk about Kevin Warsh as Fed Chairman. The Fed is not independent. They've never been independent. When somebody starts writing about the Fed losing its independence, it's a canard; just ignore it. They're all politically appointed. They're all beholden to their member banks.
Even their mandate, while it's used to drive the narrative of independence, they only care about inflation and employment as it relates to its impact on the member banks and capital markets and the ability of the government to fund itself at a cost of capital that's affordable. That's it. They do not care if your eggs go up. They do not care if your housing becomes unaffordable. And they've demonstrated that through all of their policy actions.
I think Greenspan, you know, kind of roped independence and hog-tied it. And then I think Bernanke and Yellen put it on an altar and set it on fire and sacrificed it. What I mean by that is they gave up any policy flexibility with the policies they chose, post the financial crisis. So all we're trying to do is some form of renormalisation.
If you go back and look at the entire history of central banks, ours included as well as others, there are decades when all the central banks do is financial repression to support deficit spending at the federal level or to support industrial policy at the behest of a central authority, whether it's a federal government or whatever that may be.
So feds are never independent. Let's just acknowledge that. So we just need to understand the policy paths that they have in front of them, look at what they choose, and then accept the economic consequences of that and what that means to capital flows, cost of capital, and who benefits and who is hurt by that.
So that's kind of the framework that we're going to use. You know, Kevin Warsh made a lot of comments pre-financial crisis and during the financial crisis; that would say he's hawkish. But what he said wasn't unusual at the time, which is, "Hey, QE could be inflationary." It depends, right? It depends on what the Fed does with the reserves, how they manage the ballooning of the reserves and the financial system. And clearly, the QE that we experienced over that period of time was not inflationary.
So you can say he's going to be more hawkish. The guy worked for Druckenmiller, he's married into a billionaire family, he's good friends with Bessent. The idea that this guy isn't an insider and isn't going to be supportive of capital markets is crazy. There's no question that I think he will cut rates because they should cut rates.
I know he's talked a lot about shrinking the balance sheet. I think that's nice to say, but it's like everything. When you're outside of the position, you can critique it; once you get in the position, you know, shrinking the balance sheet isn't easy.
It's easy to pick what assets you want to get rid of, but okay, what liabilities are going to go with them. So it's going to be very conditional, dependent on whether or not the Fed will be able to shrink their balance sheet. And there are ways it can be done that's net neutral to risk assets at best, but by and large, it creates turbulence within financial markets for the Fed, given where we are today, to shrink its balance sheet. So I would ignore that side of it.
I don't think there's any question that they want to shift power away from the Fed and towards the Treasury, and that's not necessarily a bad thing. The question is, how would they do that?
So I do think Kevin Warsh's appointment is going to lead to more coordination between the Fed and the Treasury, and quite frankly, that should be welcomed given the challenges we face, given the amount we need to spend and given the current deficits. And I think they'll do it in as benign a way as possible. It doesn't mean it has to be as supportive as they have historically been for financial markets, but his appointment isn't raising any concern for me.
I mean, we're in a tough spot. We all know it. There's going to be some collateral damage and there's going to be some collateral opportunities no matter what policy choices we make from here.
Dan: Thinking more about what's taken place in the market recently, the first week here of February. Year to date we have seen a continued market rotation. Some of the previous leaders in the Magnificent Seven have really broken down, and we've seen a strong rotation into US small and US mid on the domestic side. And then as we've seen continued strength in the equity markets outside of the US, do you believe that these moves are sustainable? Are they driven by earnings, fundamentals, or is this really a big AI disruption fear that's causing a bit of a temporary repositioning?
Chris: I think it's fundamentally driven, and this isn't new. It's just coming to a crescendo where people are watching their largest holdings, whether they own a passive index in the form of the Nasdaq-100 or the S&P 500.
We saw the broadening of stock performance last year. We saw emerging markets outperform the S&P; foreign domestic performance outperformed the S&P. We saw broadening and strong performance in the back half of the year, out of small caps, micro caps, regional banks. All of that is indicative of exactly what we said we're going to see: an improvement in economic activity, and now we're getting confirmation that we're likely to see much higher ISM figures out of the United States. We're seeing it in Q4 earnings releases where small-cap earnings are growing, mid to high teens, if not into the low 20 percent.
So we're leaving an environment where the Magnificent Seven dominated because of flows, and those flows were driven by one, people seeking growth and growth was limited in the equity markets globally, so it crowded money into the US and into the S&P 500 that was dominated by tech.
Now we're seeing growth broaden, because we're seeing populist policies developed around the world. Those aren't going to stop, so those policies are going to continue to drive growth in other areas of the market. And everybody was way over-positioned into US dollar risk assets and into US large-cap tech. And so if they want to go buy those other things, they have to sell what they own in order to do that. And so that creates these rotations. Look, I think it's going to stay in place through the first half of this year.
We've already seen a significant rotation, so I'm not here to say that it's going to continue at the same rate as the last three or four months, but it certainly could.
Once we get past the second quarter, it's really going to depend on a couple of things: where are we with policy implementation, where are we with the Treasury's plan to increase the TGA account over the next couple of months. That will be liquidity-negative for markets, and then they're going to run it into the economy, and that will flow through to capital markets and the economy.
If we gain enough traction and enough growth outside the US, then we can continue this through 2026. But there's no question that the US and Europe are making the decision to pursue more fiscally driven, fiscally supported growth initiatives because they need to. There are a lot of poor policy choices being reversed.
At the same time, we’re going to go through a normal energy cycle due to underinvestment, so capital will move into energy capex, which also drives cyclical recoveries, industrial activity, and a broadening of growth. So all of these things are very normal, and they should be expected; they just happen to be occurring at a time when there is disruption from AI. The amount of spending by incumbents to protect their market share is getting excessive, and there are reasons for concern over the intermediate term about whether those fears will manifest over the next three to five years.
But for the most part, people only own those shares because they were going up. Now the narrative is being called into question, and they’re seeing earnings growth and better performance elsewhere. And let's face it, people—they’re like lemmings; they’re going to chase performance. So I do think it’s more than a little bit of a head fake. I do think it’s policy-driven. I think it’s driven by capital flows and the capital cycle. The US is starting to cut rates. We may see Japan and others raise rates, so to the extent capital flooded into the US, it might move elsewhere. Again, they have to sell what they own, which, for the most part, is the S&P 500.
Dan: All right, good deal. Well, good having you back. A good one to kick off with this year, and we’ll see you here soon.
Chris: Sounds good.
