Powell Is Now The Fed Chair Front Runner - Less Negative Market Impact Than Warsh?

Twelve companies from the S&P 500 are reporting earnings this week. The results will start coming faster next week which is why I said that was the beginning of earnings season. This means FactSet’s chart of bottom up expectations has moved to tracking Q4 earnings estimates. As you can see from the chart, estimates have been stagnant for the past two months during the time they collapsed for Q3. The skeptics of the stock market will claim the market shouldn’t rally when estimates are stagnant, but I disagree because stocks don’t immediately rally when estimates come out. For example, when estimates for 2020 earnings start becoming public, stocks won’t rally. Therefore, earnings growth declines aren’t bad as long as the deceleration isn’t that sharp and the gains in stocks aren’t too high. Q4 earnings are expected to grow 11.1%. That would be an acceleration from Q3 even if there’s a slight decline in the next three months. When Q2’s results came out, Q4 expectations came down. If Q3 results are bad or the guidance is bad, the Q4 estimates will fall much more sharply as the results are closer to coming out, meaning estimates are about get much more accurate.

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The biggest question of the year for the Fed has been when wage growth would accelerate and push inflation higher so the Fed can raise rates. As I have said, this current environment is great for stocks. Investors need to figure out what is keeping a lid on inflation and hope it continues. Obviously, it would be bad if there was a recession and the Fed couldn’t cut rates, but it seems unlikely that a recession would occur without the Fed being hawkish, the yield curve inverting, or high inflation. One way to measure the slack in the labor market is to look at the number of workers who are working part time for economic reasons. This is the number of workers who want to work full time, but can’t find a job so they work part time. Generally, part time work isn’t compensated as well as full time work. However, some independent contractors do well. Independent contractors can be part time or full time, but mostly the work is somewhere in between. It’s a full time job which is inconsistent because contacts can be amended or terminated whenever they end which is usually in the near future.

As you can see in the chart below, the number of involuntary part time workers fell 133,000. That means we are getting closer to full employment. However, there’s still a large gap between the involuntary percentage and the unemployment rate. To be clear, the scales in the chart are slightly different. It’s also worth noting that the 0.2% decline in the unemployment rate is unsustainable with 33,000 jobs lost. There must have been a quirk in the data for that to occur. If the unemployment rate would have been stable, this gap would have narrowed. In summary, we aren’t close to seeing the accelerated wage growth that the Fed wants. The slack is still here. However, the Fed is deciding to ignore the lack of inflation and raise rates anyway in December. That rate hike won’t mean much, but if such policy were to continue we’d have a hawkish Fed by the end of next year for the first time since 2007.

The biggest news on Monday was Jerome Powell taking the lead as the front runner to be selected as Fed chairman. It has been a two way race for the past few days as Yellen and Cohn have dropped. Essentially, Powell and Warsh switched odds as Powell is at 42% and Warsh is at 22%. I think this is the best pricing because Powell is more of a dove than Warsh. The Fed is already raising rates at a relatively quick pace compared to earlier in this recovery. President Trump doesn’t want to tempt fate with an even faster rate of increase and a complete unwind of QE. I’m nervous about what the deceleration of global QE will do to stocks in 2018. If Warsh was picked, my worries would be escalated. Usually it’s a good idea to worry about a recession when the Fed raises rates higher than the CPI. With Warsh, I would expect that to happen. If Yellen wants two hikes and Warsh is more hawkish than her, I’d expect as many as 4 hikes in 2018 from him. That would push the Fed funds rate to 2.25%. That would be above the CPI unless inflation increases.

As you can tell from my expectation of Warsh, stocks would fall sharply if he was picked. There would be added uncertainty to Fed policy. There would be a change in the direction of the Fed for the first time in over 10 years. Powell is a great fit because he acknowledges the situation at hand. The Fed is about increase the size of the unwind. If there is weakness in the economy or volatility in the stock market, he wouldn’t hesitate to change the direction of policy. That might not be the best direction for the country, but it would be great for stocks. President Trump loves the roaring stock market, so Powell should be considered a front runner. To reiterate, I think there’s no chance either Yellen or Cohn are picked. The decision is coming closer. If any person gets higher than 60% odds, that would signal to me that the decision is coming in a few days.

Conclusion

S&P 500 earnings are about to become a worry for value investors again if Q4 estimates repeat the decline Q3 estimates had. On the bright side, Powell looks like he is going to be picked as Fed chair. The market likes the sound of another few years of policy similar to what Yellen provided. President Trump wants some deregulation in finance and a dovish Fed. It looks like he’ll get that. I expect a Powell Fed to raise rates between 0 and 2 times in 2018. I expect the QE unwind to go as scheduled.