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Source: istockphoto.com

In the coming year or so, the Trump administration could find itself in a position of reshaping the Federal Reserve Board which has four vacancies following the sudden departure of Federal Reserve Vice Chairman Stanley Fischer on September 6.  President Trump has already nominated Randal Quarles, an investment fund manager and former Treasury official, to fill one of the slots and also oversee banking regulation.  Should Obama appointees, Lael Brainard or Jerome Powell, choose to follow Fischer’s departure, then that would leave the entire Federal Reserve Board up for reappointment, save Janet Yellen who is still serving a 14-year term as a Fed Governor. 

It’s questionable whether U.S. equity markets have fully priced in a leadership vacuum that could emerge following the February 2018 expiration of Janet Yellen’s term as Federal Reserve Chairperson.  We should point out that U.S. equity markets did react negatively to 1) news reports that Economic Council Chairman Gary Cohn would not be considered for the Federal Reserve Chairperson slot and 2) the sudden resignation of Stanley Fischer.  One could argue that the fall in long-term Treasury yields and the collapse of the U.S. dollar versus major currencies since the end of June could reflect the prospects of an uncertain Fed outlook, but these moves more likely reflect the failure of inflation to materialize versus what was expected earlier in the year. 

Should President Trump choose not to re-nominate Dr. Yellen for another four-year term as Chairperson, then Dr. Yellen would be the first Chairperson to not have his/her term extended since 1978.  Yet, U.S. markets don’t seem too concerned over the prospects of a leadership transition at the Federal Reserve since directives for setting monetary policy and providing support to the banking establishment have been largely institutionalized by economists and monetary experts spanning the tenures of Alan Greenspan, Ben Bernanke, and Janet Yellen.   Under the leaderships of Dr. Greenspan, Bernanke, and Yellen, the Federal Reserve has most likely institutionalized much of its policies and proscriptions and could be less susceptible to cult of personality driven by one or two figures. 

(As an aside, I recommend reading “Lords of Finance” written by Liaquat Ahamed – a historical narrative of central banking during the interwar period between WWI and WWII.  Fed watchers concerned about cult of personalities dominating today’s Federal Reserve should appreciate how dominate NY Federal Reserve governors, Benjamin Strong and George Harrison, were over guiding U.S. central bank policy.  Such guidance was needed because early Fed governor appointments were “carefully selected not for their expertise but to ensure due representation for the different regions of the country.”  In other words, Fed governorships served as the Plan B for marginal politicians.)

So, equity markets could be looking past the leadership transition likely to take place early next year as investors believe the Fed has institutionalized much of its behavior.  Regardless, the September 2017 WSJ survey of economists show broad support for a second term as Fed Chairperson for Janet Yellen (those polled also expect another Fed Rate increase in December despite a low probability being priced in Fed Funds futures). 

On the surface, it’s unclear whether a Trump-driven Federal Reserve would represent a significant policy direction, apart from the sharp disagreements with the current Board members over banking regulation.  Interest rates have dropped and the U.S. dollar has weakened without disrupting financial markets, which should please the Trump administration.  And from insider accounts, President Trump’s Fed Board nominations will likely possess economic policy backgrounds as well as diverse financial backgrounds ranging from academia to Wall Street and community banking.  Trump would also be incented to appoint more dovish Board members whose rate setting would be supportive of the U.S. economic environment heading into the mid-term elections. 

But, this is also an inauspicious time for uncertainty to be forming over Federal Reserve leadership just as the Fed is winding down emergency monetary policies from the 2008 financial crisis.  The Fed has started the process of winding down its balance sheet and begun the process of ‘normalizing’ interest rates off the zero-rate level that was started in December 2015.  Already some are questioning the Fed’s ability to develop accurate inflation forecasts as core inflation has come in much lower than what was expected earlier in the year (Exhibit 1).  And, despite 3rd quarter disruptive events including North Korea and hurricane activity, the financial system has been relatively stable as the Fed continues to normalize monetary policy.  How would a Federal Reserve Board, under new leadership, implement current policies in the face of financial instability?

Exhibit 1 - Inflation? What Inflation?

 

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Through the end of August, the S&P 500 has generated ~12% total return.  Based on Bloomberg consensus earnings estimates, the S&P trades at ~19x next 12 month’s earnings per share.  On a trailing 12-month basis, the S&P trades at 21x EPS (Exhibit 2).  U.S. large companies are experiencing revenue growth and multi-nationals will likely benefit from the tailwinds of a weaker dollar.  Operating margins also remain high.  With interest rates low (and dropping further), it is conceivable that U.S. equities can continue to advance, whether on earnings growth or a multiple expansion as investors price in a lower risk premium relative to U.S. Treasuries.  

Exhibit 2 – At 21x Trailing Earnings (as of 8/31/2017),

U.S. Equities Are Not Pricing in Much Fed Risk


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Perhaps worrying about the upcoming Fed transition is just another brick in the wall of worry that markets continue to climb upon.  It certainly isn’t priced in as a risk factor even though such a risk may be showing up in other markets like precious metals, bond yields, and U.S. dollar weakness.  Yet investors should not overlook the risk of a leadership transition at the Fed as it could potentially disrupt the current course of action and bring uncertainty into monetary policy.

Disclosures:

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future.  It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy.  It is for informational purposes only.  The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these.  There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results.  None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk.  The opinions offered above are as September 8, 2017 and are subject to change as influencing factors change.

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