Powell Versus Warsh
The movement in the betting market for who will be the next Fed chair was sharp on Tuesday as news leaks out about who President Trump is considering. I’ve long been high on Warsh being picked and pessimistic on Cohn and Yellen’s odds. That perspective has proven to be accurate as on Tuesday Cohn’s odds fell from 16% to 2%. Cohn has no monetary policy experience and criticized President Trump’s handling of the Charlottesville riots. It seemed like a no brainer that he wouldn’t be picked. However, it took until Tuesday for the Predict It market to realize that. Yellen is now in 3rd place with 19% odds. Since her Jackson Hole speech was in direct conflict with the President, because she defended regulations, it seems very unlikely that she will be picked. The latest person who was interviewed is Jerome Powell; he’s at 30%.
There’s a 79% chance the pick is either Powell or Warsh. Warsh is good on regulations, but he’s a hawk. Powell is an establishment dove, but he isn’t as great on deregulation as President Trump would like. For the most part, the markets are focused on the monetary policy effects of who the next choice will be. If it’s Warsh, expect a complete unwind of the balance sheet and higher rates. If it’s Powell, expect no change to the current policy. That means the balance sheet will be between $2.4 trillion and $2.9 trillion when this unwind is done. The Fed funds rate will be raised gradually as the market and economic data permit. We’re in a bizarre circumstance where polar opposites are being considered. This means that the next few days will have big impacts on the market. President Trump will make his selection sometime in the next 3-5 weeks.
When Warsh’s odds improve, expect a selloff in tech stocks and a rally in the banks. The FANG stocks are negatively impacted by rising rates and the banks are positively impacted as their net interest margins improve. Powell would have the opposite effect, causing a snapback rally in tech stocks and small cap banks to fall. Warsh would also cause a selloff in bonds. You can see the recent action moving in this direction in the chart of the 2 year bond below.
Personally, I have always been in the Warsh camp since I started reviewing the candidates a few months ago. However, that was before Powell was an option. Now that he is a candidate, I don’t have a distinct edge. It depends on if President Trump cares more about being dovish or cutting regulations. The President also could tell Warsh to be more dovish or tell Powell to cut bank regulations. At that point, it would depend on which candidate is willing to listen to him and change their perspective slightly. Considering Warsh’s renegade persona, I think he would be the most likely to change his stature. Powell has spent years working with regulations; if President Trump asks him to do something he disagrees with, there’s no way he changes his mind.
On the other hand, Warsh might bend a little to get the position. I don’t think President Trump would ask him to alter his opinion on unwinding the balance sheet or changing or his opinion that the Fed focuses too much on decimal points and the latest economic data. You can see the summary of Warsh’s positions below. President Trump would want the Fed to still care about the market reaction and have low rates. The question is if Warsh is willing to compromise to get some of his agenda put into action. I think he would because he must recognize that not all of his big ideas will be executed. He probably would rather get something done, then have the Fed be run by people he vehemently disagrees with. Powell is an establishment monetary policy person even though he doesn’t have a PhD. He might think it’s unbecoming to guarantee the President he is going to crack down on regulations.
Earnings Update
We’re currently in the dead zone two weeks before earnings are going to start being reported. Sometimes we see earnings expectations drop quickly at this time because analysts realize what firms will likely report and make their estimates slightly below those expectations so companies can beat them. This quarter is likely different because estimates have come down so quickly already. The year over year earnings growth is only expected to be 4.2%. As you can see from the chart below, there has been a modest improvement in the bottom up Q3 EPS estimate in the past week. I am more curious about this quarter’s earnings reports than I have been in a while. I think the pessimism is overdone if the only weakness is caused by the hurricanes. It seems Harvey had a much bigger impact on business activity than Irma. A lot of rebuilding will be included in this quarter which means there will be positive effects to counter the negative effects of business being temporarily shut down, raw materials price increases, and transportation of goods delays.
The S&P 500 chart below breaks down the sectors which have been the hardest hit by the consensus downgrades. As you can see, energy went from being expected to have 157.3% growth to being expected to have 109.4% growth. Last week I would have said this negativity in the energy sector could be met with some bullish guidance as oil prices were rebounding. However, in the past few days oil has fallen about $2 to $50.38. The decline Tuesday was caused by a report by Reuters that said OPEC’s September crude output was 32.86 million barrels which is up from last month and above the cap. The compliance rate was only 86%. We’re in a seasonally weak period for oil, so it might fall below $50. Libya’s production hit a 5 month low. If the country’s biggest oil field comes back on line, it will probably cause oil prices to fall further. This all makes buying energy stocks before earnings season a dubious bet.
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