Bull market can’t last if you mind the gap

In some Underground stations in London, you are repeatedly reminded to “Mind the Gap” as you enter and exit the train.

The aim is to reduce injuries occasioned by a structural anomaly that results in a large gap between the platforms and the trains.
Judging from market valuations, I sense quite a gap between consensus market expectations and key political and economic realities, especially in the US. If the gap isn’t bridged by the validation of the more optimistic expectations, investors may well find that January’s global equity sell-off was just a precursor to a disappointing year for several asset classes, including stocks.

I am not a political expert but I respect and listen to the insights of many who are. Their messages are eerily consistent, and quite concerning.

The political atmosphere in Washington is tense and increasingly polarised. Bipartisan backing for measures is harder.

With the political center shrinking, the ability to “manage to the middle” is growing more elusive while the more partisan wings don’t command sufficient broad-based support.

The situation isn’t helped by the diminished trust in key institutions, both public and private. Policy decisions, past and present, are second-guessed. Banks’ standing in society is severely shaken. The regulatory framework is in flux, with agencies fighting for turf. And the divide between large and small firms is as big as I have ever seen it, as is the disparity between the rich and the less-fortunate segments of the population.

Growth undermined
All this comes at a time of great economic fluidity and challenge. The global financial crisis has undermined growth and job creation; it has clogged many of the pipes that allocate funds to productive uses; and it has rapidly taken public debt and the budget deficit to worrisome levels.

I am particularly concerned about the surge in joblessness. In the absence of bold structural measures, most of which face political headwinds, we are looking at a period of persistently high unemployment that will disproportionately affect the young.

We risk significant welfare losses and skill erosion, lower labour-market flexibility, and yet another burden on the country’s stretched public finances.

These are consequential political and economic questions. They speak to a more protracted post-crisis resetting of the US economy — what Pimco labelled last year as a bumpy multiyear journey to a new normal.

All this is consistent with the academic literature on post-crisis periods. Such research reminds us of the extent to which massive disruptions — such as the one experienced in 2007-09 — expose structural cracks that, at best, can only be masked temporarily by a massive cyclical policy response.

Resetting the US
To make things even more complex, the resetting of the US is occurring in the context of secular shifts in global growth and wealth dynamics — principally on account of some systemically important emerging economies (such as Brazil, China and India) having reached development breakout stages.

The evidence is overwhelming: Economic and political indicators are urging us to adopt a forward-looking structural mindset. Yet too many markets — and, I would also argue, too many private and public institutions — seem hostage to cyclical forces.

This inconsistency is apparent in the seemingly unquestioned manner that so many have assumed in regard to the following six scenarios for 2010:

— First, an orderly handoff from temporary sources of growth (think government stimulus and inventory rebuilding) to sustainable components of final private demand.
— Second, a smooth exit from unconventional measures, with policies regaining much-needed degrees of operational flexibility.
— Third, the government’s delivery of a credible, pro-growth medium-term fiscal adjustment program.
— Fourth, a rebound in bank lending that alleviates the enormous pressures facing small businesses.
— Fifth, the ability to defend the institutional integrity of key public institutions.
— And finally, effective global policy coordination.

A more realistic assessment of these factors would caution against an excessive focus on changes in growth rates at a time when absolute levels are horribly out of whack.

It would encourage greater awareness of what the important insights of behavioural finance tell us about the challenges of navigating regime changes and resetting systems. And it would remind us to mind the gap between structural realities and cyclical fantasies.

The longer this is delayed, the greater the scope for policy mishaps and market disappointments.

(Mohamed A El-Erian is chief executive officer and co-chief investment officer of Pimco, the world’s biggest debt manager. The opinions expressed are his own.)