While most investors and pundits are currently focused on optimistic analyst earnings estimates for the coming year there’s another far more important phenomenon underway that deserves more attention. Three years ago Stan Druckenmiller gave a very important speech to a very exclusive group of listeners in which he disclosed the single greatest source of his tremendous success as an investor: central bank mistakes. Well, it looks as if some at the Fed are beginning to worry, like Stan, that they have now made the same mistakes they made in prior cycles all over again.
‘Asset prices may have become distorted relative to the economic fundamentals and the very slow pace of our balance sheet normalization may still be contributing to a buildup of various financial imbalances.’ -Kansas City Fed President, Esther George https://t.co/qw4GvUn8FS
— Jesse Felder (@jessefelder) March 9, 2018
In that same speech several years ago, Druckenmiller also disclosed what he sees as the single most important factor behind major market moves:
Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.
And the Fed is not only removing liquidity now, according to Ms. George, the they are clearly considering doing so at an even faster rate in the future. This has important implications for asset prices.
It’s the Fed, Yanking The Punchbowl https://t.co/OZbRF7rJeH by @McClellanOsc pic.twitter.com/pDJ5yrIOn8
— Jesse Felder (@jessefelder) March 4, 2018
It’s important to note, too, that it’s not only Ms. George expressing more hawkish views today. As indicated by her colleague, Lael Brainard, hawishness at the central bank, it seems, is now the consensus. As Edward Harrison wrote this week:
New Fed Chair Jerome Powell used his first public remarks before Congress to say so. His view: “While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds”. Don’t let the understated language fool you. This one sentence encapsulates a marked shift in tone. And now policy dove Lael Brainard is onboard too. The fact that she is giving the first major speech after Powell echoing the same theme is significant. It tells you that the messaging is coordinated. And it also tells you that there is a general consensus on that messaging.
Lael Brainard turning hawkish signals an important regime shift in US monetary policy. https://t.co/jnwTB4iPhP by @edwardnh
— Jesse Felder (@jessefelder) March 8, 2018
And if the Fed is now determined to remove the punch bowl they have a lot of tightening yet to do. After today’s jobs numbers the probability of 4 rate hikes this year climbed to roughly 30%. Even that would only take the Fed Funds rate to the 2.25-2.5% range while the Taylor Rule suggests it should already be closer to 4%.
Still easy after all these years https://t.co/DjQUHndH1B by @charliebilello pic.twitter.com/s72DolrTlA
— Jesse Felder (@jessefelder) February 21, 2018
Certainly, it’s beginning to look as if the Fed is not only behind the curve today but that they may soon be forced to take more drastic measures to tackle rising inflation. As my friend, Eric Cinnamond, has been chronicling for some time now the consensus among companies is that inflationary pressures are now as great as they have been in many years if not decades.
‘Based on my bottom-up research, evidence of a tightening labor market, cost pressures, and pricing actions continue to build and increasingly suggest our central bank is falling behind the curve.’ https://t.co/2pytpRGh2X
— Jesse Felder (@jessefelder) March 4, 2018
For now, it seems the popular market narrative, reinforced by today’s jobs report, is that the economy finds itself in a “goldilocks” scenario: not too hot so that the Fed feels the need to cool it off but not to cool to put a damper on the uber-bullish analyst estimates of company earnings for the coming year.
"Goldilocks" pic.twitter.com/V5fvmM9TuT
— Jesse Felder (@jessefelder) March 9, 2018
However, if the narrative continues to shift from the “goldilocks narrative” (which appears to have peaked last year) into greater agreement with all of these companies pointing to inflation markets could be forced to rapidly reprice their current, rosy assumptions about fundamentals and Fed policy.
‘By August 1987, equities were at record highs, the Fed was raising rates, the U.S. dollar was under pressure and there were increasing concerns over inflation and the Fed being behind the curve.’ https://t.co/gSVBDOPf9h
— Jesse Felder (@jessefelder) February 20, 2018
For these reasons, investors may want to focus more on what is going on with inflation at the individual company level and, more importantly, on the Fed’s reaction to those developments rather than on Wall Street’s current “goldilocks” narrative. At the end of the day, as Druckenmiller says, “earnings don’t move the overall market” and Wall Street’s not very good at predicting either anyway, especially at major turning points.
‘Market history shows that the faster profits grow, the worse stocks perform, especially when multiples are already high and inflation is rising.’ https://t.co/QegeKlPjO3 ht @hmeisler pic.twitter.com/Sh1cABM9JZ
— Jesse Felder (@jessefelder) March 9, 2018