Volume 84 October 2017

Traditionally, the selection of the next Chairperson of the is anything but a compelling drama or anything worth paying particular attention to. To the contrary, the

identity of the nominee is normally a foregone conclusion as, since World War II, every Chairperson who completed a first term has been nominated for a second term.

In an environment of such clarity, many investors have largely ignored the nomination process, as the presumed nominee is well-discounted by the markets well in advance of the actual nomination. There is virtually no drama or suspense.

However, the current nomination process has been anything but normal, and there are a number of significant reasons why this particular appointment could have longer-term, game-changing ramifications.

The first reason is that President Trump is looking increasingly likely to bring in a new Federal Reserve Chair at a critically important time in our history. That is not to downplay in any way the extraordinary challenges faced by Chairman Bernanke, who used unconventional and largely experimental monetary tools to rescue the global economy from a replay of the Great Depression, or Chairwoman Yellen who has so deftly started normalizing interest rates and prepared the markets for the ultimate unwinding of the Fed’s multi-trillion-dollar quantitative easing stimulus programs.

The presumed new Fed Chair is going to be responsible for not only carrying forward their predecessor’s policy of higher interest rates, but also oversee the domestic and global economies, as the world’s various central bankers slowly drain much of the excess monetary liquidity which has supported and helped to drive higher this historic reflation in financial assets (stocks, bonds and real estate).

This is without precedent, as the world has never before seen such a massive, global and pro-active shrinkage of the world’s money supply. From our perspective, it is a less-than- ideal time to change jockeys, particularly when the current jockey, Janet Yellen is almost certainly the most qualified person on earth to do the job.

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Despite the fact that Yellen is a Democrat nominated by President Obama, President Trump himself has acknowledged the superior job that she has done. As he recently put it, “She was very impressive. I liked her a lot. I mean, it’s somebody that I am thinking about.” But, he continued, “I have to say you’d like to make your own mark.”

This comment is hardly surprising given how important absolute loyalty is to the President. Moreover, the presumed replacement of Yellen would not necessarily be such a terrible thing, if one was confident that she would be replaced by someone with comparable insight, experience and expertise.

Unfortunately though, one cannot make that assumption, as some of the candidates reportedly on President Trump’s short list to lead the Federal Reserve have the potential to be very detrimental to the economy and the financial markets.

Whoever is ultimately selected to fill the top position at the Fed already has an uphill battle even under the best of circumstances, as investors are currently pricing in a future path for monetary policy that is far more dovish (i.e., investors expect rates to stay lower and for longer) than what has been detailed in current Fed guidance.

Current market expectations, as illustrated by futures prices, are for a likely third 2017 rate hike in December, but only one more rate hike in 2018 (a total of four hikes over the two- year period: the yellow line), which is much less aggressive than the seven rate increases that the Fed is telling investors to expect over the period.

This suggests to us that short-term, market-set rates will likely need to move higher regardless of the new Fed chair, and that they might be forced to move higher rapidly, if candidates like Warsh or Taylor were to move into positions of influence.

Also noteworthy is the unconventional way in which the President is making his selection. To explain, a president normally decides what attributes they want in the leader of the Fed, and then goes about selecting between candidates that share those same attributes and philosophy about monetary policy.

In contrast, President Trump has reportedly assembled a short list of candidates that represent almost every conceivable view on monetary policy and Fed operations, ranging from Jay Powell, who is viewed as a Republican version of Janet Yellen, to Kevin Warsh and John Taylor, who have been among the Fed’s loudest critics, and who want to dramatically reform the structure and operations of America’s central bank. Each would also be expected to significantly accelerate both the trend towards higher rates and the rate of shrinkage of the Fed’s quantitative easing stimulus.

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The Chairperson of the Fed is in a very powerful position, and can usually control the monetary policy discussion. However, they do not act alone, which might normally provide some comfort that, even in the event that President Trump nominates a fairly radical reformist (who would also need to be approved by the Senate), they would be effectively constrained by the other board members.

However, with Vice-Chairman Stanley Fischer retiring in November, and Chairwoman Yellen’s first term ending in February of next year, President Trump will get to nominate at least three more candidates to the Fed Board of Governors.

Since he has already appointed one governor, Randal Quarles, it means that President Trump will get to appoint at least four of the seven members of the Fed Board of Governors. Of the two existing governors not being considered for Chairperson, one, Mr. Quarles, favors major reform of the Fed and a faster unwinding of the quantitative easing programs, and one, Lael Brainard, is a more traditional Fed governor who favors continuing the current “slow and steady” unwinding of the Fed’s historic stimulus programs.

Everyone expects that Janet Yellen, who has always been considered a fairly dovish voice, will leave the Fed if not reappointed as Chairwoman, which would cost the Fed one of its biggest advocates for continued Fed independence, and one of the strongest proponents of a slow and steady normalization of monetary policy.

When fully staffed, the seven members of the Federal Reserve Board account for the majority of the twelve members that vote on monetary policy. The other five votes come from Presidents of the various Regional Federal Reserve Banks.

The bottom line is that President Trump has an opportunity to reshape the Federal Reserve to an extent that could change the outlook for monetary policy and how it is determined for years, if not decades, which is why it is so important that he get this right. In fact, he needs to get it right multiple times, as each of these appointments is of such critical importance.

One other consideration that might be of particular interest to investors is how the Fed will, under new leadership, react to the potential passage of a big fiscal stimulus/tax package out of Washington, D.C., particularly when it is being proposed at the worst possible time in the business cycle, when the Federal Reserve is already tightening monetary policy to keep the economy from running too hot and creating an inflation problem.

Granted, the United States badly needs tax reform, albeit something much more substantial than what is being proposed, and we understand that, as a politician, you need to take what you can get, when you have the votes to get it.

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However, by introducing a large fiscal stimulus program near the end of one of the longest economic expansions in history, it simply creates an environment where the Federal Reserve will likely be forced to become more and more restrictive on monetary policy, with the purpose of offsetting the inflationary risks caused by the fiscal stimulus. This is a lesson that President Reagan learned in 1981, when the Fed sharply raised rates to offset the stimulative effects of the big Reagan tax reform plan.

This is of critical importance, because the proposed tax package is estimated to balloon the deficit by $1.5 trillion unless it proves to be so stimulative to the economy that tax revenues will increase sufficiently to offset all of the revenues that were given up as part of tax reform.

The problem is that the Fed is very unlikely to allow that to happen at a time when the economy is already running so close to full capacity, and the Fed is worried about the prospects for future inflation. Since monetary policy normally overwhelms fiscal policy, the most likely outcome may turn out to be lower taxes, but a bigger national debt, a flatter yield curve (which reduces liquidity in the financial system) and a slower economy.

It would be like a company borrowing money just so that it can increase its dividend. It provides some instant gratification, but is normally quite detrimental over the longer term.

Further, unless the tax cuts can avoid increasing the deficit, they must, by law, be only temporary, which suggests that they would likely not be very stimulative, even if the Fed decides not take steps to offset them. To explain, according to Milton Friedman's Permanent Income Hypothesis, consumers only spend money that is gained through a source considered to be permanent (like a raise), and tend to instead just save any additional money gained from a temporary source (like a rebate or temporary tax cut).

Ironically, the above scenario of a potential monetary policy offset to fiscal stimulus (i.e. tax relief) may be the only instance in which John Taylor would be viewed as an investor- friendly Fed Chairman, as he does not believe that fast economic growth causes inflation, so he might be less inclined than would be the other candidates to offset fiscal stimulus with tighter monetary policy.

While the odds of nomination seem to be shifting strongly towards Powell, the bottom line is that nobody knows who President Trump will nominate. He has made a number of unorthodox appointments in the past, and he does have a flair for the dramatic. Reportedly, we will find out on November 2nd.

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Importantly, each of the major candidates has their supporters. Vice-President Pence and many conservative Republicans, who have largely misguided ambitions of reforming the Fed and bringing it under the control of Congress, support Taylor and his reformist mandate. Treasury Secretary Mnuchin, who leads the search committee, favors Powell, who is experienced, non-controversial, and who should easily sail through confirmation hearings in the Senate.

There is also at least some evidence that Trump still favors Yellen, despite the strong objections of his inner circle, because she is the one that the markets would like the best, and he likes to claim credit for the stock market going higher.

Aside from the three presumptive finalists, Yellen, Powell and Taylor, there is one candidate, Kevin Warsh, who may also find his way into one of those vacant seats. Warsh, who was once considered as the leading candidate for the chairmanship, has no formal training, and seems to be primarily qualified by his friendship with President Trump and his ability to become a billionaire by marriage.

He was a Fed governor before, in the midst of the financial crisis, when he fought against every emergency program introduced by the Fed to stabilize the global economy and instead warned that the Fed’s programs would create global hyper-inflation. He wrote an article in the Journal this year that former Treasury Secretary Lawrence Summers called “the single most confused analysis of US monetary policy that I have read this year”.

The markets would be ecstatic if Janet Yellen were to get the appointment, and very comfortable with Jay Powell. In contrast, we believe that the markets would be very uncomfortable with a Chairman like John Taylor, who would introduce a whole new level of market uncertainty (investors tend to despise uncertainty above all else).

Taylor believes that the economy could grow much faster, and in a more sustainable way, if the Fed would just stop getting in its way. He formulated several versions of the “Taylor Rule”, which is an econometric model designed to determine the optimal level for the Fed Funds rate based upon the economy’s output gap. He maintains that such models should replace human discretion in the setting of interest rate policy. Importantly, each of his models would have interest rates much higher than they are today.

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Of course, the flip side to monetary policy is fiscal policy, and there is a growing, albeit still modest, potential for some sort of tax deal, the passage of which we would expect to be a negative for municipal bonds, as it would reduce their relative attractiveness, and very beneficial for stocks, whose earnings would increase by an estimated 11% to 12%, if the tax bill passed as currently proposed. We would expect for stocks of smaller companies to be a particular beneficiary of the proposed tax cuts, which also makes them particularly susceptible to negative news regarding the outlook for the plan’s passage.

Indeed, we suspect that smaller- capitalization stocks are the one area where the potential of tax reform is starting to be reflected in share prices, which suggests that small caps will be the stocks that suffer the most, if tax reform does not pass.

The so-called “smart money” is still betting against the successful passage of a tax bill. You can see this reflected in a couple of ways. First, if you look at the PredictIt prediction market, punters are giving the passage of tax reform in 2017 only a 20% chance of success. Second, if you compare an equity index representing stocks of companies that pay low tax rates to one of companies that pays high tax rates, you will see that “low-tax” stocks continue to dramatically outperform their “high tax” brethren. This should not be the case if the markets were pricing in tax reform, as lower tax rates would bring the greatest relative benefit to the most highly-taxed companies.

In general it should be viewed as a good thing that investor expectations for tax reform remain low, as that suggests that there is still significant upside potential for stocks if tax reform passes, particularly since the expected boost in earnings is not reflected in current analysts’ profit estimates. It is also probably good news, as it suggests that any equity market disappointment associated with the potential failure of tax reform should be relatively minor, since it does not seem to be, with the potential exception of small-cap stocks, very fully reflected in current equity prices.

There does appear to be one current impact of the tax-reform debate on securities prices, which is that there appears to be a hesitancy to sell securities in 2017, when they might be sold at lower tax rates in 2018. While this would help to explain the equity market’s virtually uninterrupted uptrend and diminutive volatility, it may also just be deferring pent-up selling pressure and profit-taking into early next year.

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