The Economic Numbers: Why Markets Aren’t Getting Carried Away As Yet

Similar to what happened last week, this morning’s better-than-expected economic data (focused on retail sales) and solid company earnings (Citi) resulted initially in a somewhat limited overall market reaction. I suspect there may be two reasons for this.

First, the improvement in economic data, while notable, is not sufficiently strong – at least as of now – for “escape velocity.” Or stated another way, despite better numbers, the US economy is yet to transition properly to a period of strong, sustained growth.

Specifically, indicators of concurrent GDP growth remain in the sub-2% range. Markets are also worried about a host of potentially disruptive influences, including the fiscal cliff. 

Second, equity prices are already above what strictly would be warranted by economic fundamentals.

The reason, as argued last week, is a set of hyper active central bank policies committed to maintaining a significant policy wedge between  markets and underlying fundamentals – not as an end in itself but, rather, with a view to calming investor concerns about fundamentals, fueling animal spirits that drive consumption and investment, and also triggering the wealth effect.

The hope for the Fed and others is that a string of economic data improvement would culminate in a critical mass that markedly moves fundamentals up towards current valuations, and thereby establish the basis for another market surge. And the data over the last few days – including jobless claims, consumer sentiment and retail sales – provide comfort in this regard.

However, there is a risk that the Fed will remain the only policy game in town. In such circumstances, its policy wedge would be increasingly undermined by internal inconsistencies that are becoming more apparent. And the more the wedge weakens, the greater the possibility of prices converging down to fundamentals (rather than the other way around).

Stay tuned. It will be an interesting few months.

Photo: serenitbee/Flickr, used under a Creative Commons license.

This article contains the current opinions of the author but not necessarily those of PIMCO. Such opinions are subject to change without notice.  This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.