Investors, don’t bank on a second-half U.S. recovery

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Mohamed El-Erian, the former CEO and co-CIO at Pacific Investment Management Co. LLC, has joined the chorus warning of rising market risks that bear a disturbing resemblance to the 2005 to 2007 period preceding the financial crisis.

Combining Mr. El-Erian's view with the work of others, it's apparent that despite the Fed's best efforts, the U.S. economy is returning to a previous, slower growth path that will limit the success of growth stocks for investors worldwide.

Mr. El-Erian was atypically blunt in his most recent column for the Financial Times: "It is time for highly exposed investors to gradually take some chips off the table."

He believes that global investors are buying assets that are priced for perfection at a time when the actions, or inaction, of central banks and corporations suggest they are concerned about the future.

Credit spreads show the highest-risk segment of the corporate debt market is almost as expensive as during the pre-crisis credit boom era. In addition, the S&P 500 has a forward price-earnings ratio of 16.5 times, despite last quarter's anemic 2.7-per-cent sales growth and 4.7-per-cent profit growth.

The investor optimism reflected in these valuation levels is not shared by corporate leadership. Despite low interest rates and huge cash hoards, corporate investment remains slow.

Investors appear overly optimistic about the future of growth and aggregate profitability. A chart presented by Walter Kurtz in his economics blog Sober Look suggests why: Investors are pricing in a credit-bubble environment that no longer exists.

The blue trend-line on the chart represents the path of U.S. GDP growth from 1991 to 2007. This was an extended period where a mistaken belief in the Great Moderation – that ultra-loose Federal Reserve monetary policy had triumphed over the economic cycle – led to the gluttonous credit binge that caused the financial crisis.

The lower, red line represents the new trend, one flattened by the process of consumer deleveraging, demographics and slower overall consumer spending. Mr. Kurtz is succinct in his summary: "The real trend is the [lower] line. Extrapolating the 'bubble era' trend is suggesting that the credit/housing bubble was the norm."

Call it secular stagnation: The world's largest economy – one which determines Canadian gross domestic product growth to a significant degree – appears to have entered a flatter, slower growth path, and this slower growth has occurred despite the near-limitless injection of central bank monetary stimulus.

The Federal Reserve is now reducing monetary stimulus, which has sent U.S. mortgage applications into a tailspin. Yet both bond and equity markets are priced expensively, in expectation that the previous credit-boom growth environment is set to return. There is scant evidence this is the case.

For Canadian investors, the new trends imply they should not position portfolios for an accelerating U.S. economy – and this includes Canadian exporters expected to benefit from rising U.S. economic activity. For all of the annual "second-half recovery" predictions of major economists, the current sluggish growth path might be all the recovery we're going to get for the foreseeable future.

The blue trend-line on the chart represents the path of U.S. GDP growth from 1991 to 2007. This was an extended period where a mistaken belief in the Great Moderation – that ultra-loose Federal Reserve monetary policy had triumphed over the economic cycle – led to the gluttonous credit binge that caused the financial crisis.