Drucker: Economic fundamentals play second fiddle to liquidity

Vanessa-Drucker-480-FW-Index.jpg

Despite the flood of commentary and controversy over Fed chairman Bernanke’s comments last week, the principles are dead simple. The question is, are markets primarily being driven by liquidity or economic fundamentals, and which driver ultimately predominates?

The dam broke after Wednesday, when Bernanke offered a slightly more explicit schedule for the drawdown of asset purchases, which are currently running at $85bn per month. The current plan is to ‘taper down’ this autumn, until mid 2014, assuming unemployment falls to 7 per cent. But the chairman stressed that actions remain contingent on incoming data. So if the economy and labor markets improve, will that tailwind be enough to counteract the withdrawal symptoms of tighter money? Probably not. The Fed’s sugar high is more important to markets.

Remember that the S&P 500 raced up 14 per cent this year, topping out on 21 May, the day before Bernanke’s first tapering warning, when he announced the Fed might reduce its asset purchases in “the next few meetings”. The so-called Bernanke put took another blow last Wednesday, when the Dow tumbled 206 points, or 1.4 per cent. President Obama had also just hinted, in a 17 June TV interview, that Bernanke would be leaving the Fed in January, another clue that tapering may start well before the chairman’s departure.

Good economic news is not good enough for Wall Street. Never mind that the American economic picture has been generally positive, with household debt down by $1.5trn and inflation under control at 1.1 per cent. Larry Summers, Obama’s former top economic advisor, discussed last week how the housing sector has turned decisively, suggesting 3 per cent GDP growth by year end, accelerating into 2014.

Investors have bought equities with gusto this year, encouraged by economic progress. The real economy of Main Street, however, moves at a much more sluggish pace than financial markets. The Fed’s sugary punch bowl gave the bull five roaring years. But Main Street still suffers, with 12m people unemployed, whatever the trickle down results of the wealth effect. Now is time for some grinding economic catch up, as markets move sideways, backing and filling.

Vanessa Drucker is the American editor of Fund Strategy magazine