The current bull-run in markets worldwide has raised expectations of an optimistic scenario in the global economic recovery. The S&P 500 has increased by about 17 per cent between end March and early July.

The world MSCI index is up 11.9 per cent on a year to date basis, the Citigroup world bond index is up 7.4 per cent.  Even the infamous emerging markets asset class is buoyant.

The MSCI emerging markets index is up 16.9 per cent and the emerging markets bond index is up 20.2 per cent. This article tries to illustrate the dichotomy between the robust performance of financial markets and the relatively weak drivers of global growth.

The 1990s epitomises the Chinese proverb 'May you live during interesting times.' The promise of a new era led to rising stock prices of technology companies in the US, which then spread worldwide, synchronising the business cycles of developed countries.

The immediate productivity gains from technology investments led to a massive increase in technology spending. In fact in the US, a substantial portion of the capital investment was related to technology spending.

The Nasdaq crash in April 2000 and the decline in business capital spending led to the economic slowdown. This was probably the first time in post-war history; the US had a business investment led slowdown.

Another unique factor is the dependence of the rest of the world on the US for growth.  Japan has delayed its day of reckoning for dealing with its economic malaise. Europe has not addressed the problem of structural rigidities.

The savings short US economy still continues to serve as an engine of global growth, with the rest of the world financing its growth.  The robust US consumer demand for cars and houses has mitigated the economic consequences of the bursting of the equity bubble.

During the last three years, equity markets have been bogged down by uncertainty about the prospects for growth.

The US has been using fiscal and monetary policy to jumpstart the economy.  Interest rates have been steadily brought down to the lowest level in the past 45 years. Tax cuts of approximately $ 200 billion are being unleashed over the next 18 months to boost consumer spending.

One of the caveats here is that the states and local governments in the US have a budget gap of $ 78 billion that will, to some extent, blunt the overall impact of federal tax cuts.

The US budget deficits are expected to increase to 4.6 per cent of GDP and current account deficit to 5.4 per cent of GDP.

The era of twin deficits is back again. The growth prospects in the euro area and Japan are also dim. Japan has exhausted the potency of its monetary policy. Japan's budget balance is expected to reach 7.7 per cent of GDP.

Europe has some more fire power left in its monetary policy. The 20 per cent appreciation of the euro over the last year has left the euro area gasping for growth. Germany, the largest euro economy may be dangerously close to deflation.

Of the three major growth engines in the world, Japan is already in deflation, Germany is close to it and the US is desperately trying to avoid it. If the present pump priming fails, we would have an unprecedented economic problem.

Despite the rhetoric from central bankers on the use of non-conventional tools, there is no empirical evidence of their efficacy in the present situation. While there will certainly be a short-term spurt in growth, it may not last more than six to nine months.

The reason for the anticipated ineffectiveness of the policy stimulus is that it takes time for bubble-induced expansion in capacity to get rationalised. There are two dimensions of today's problem: weak demand and excess supply. There are no quick fixes to this problem.

As per The Economist poll, the US economy is forecasted to grow at 2.2 per cent in 2003 and 3.3 per cent in 2004. This is still below the long-run average of 3.5 per cent.  The euro area is forecasted to grow at 0.6 per cent in 2003 and 1.7 per cent in 2004.

Japan is expected to grow at less than 1 per cent. The low level of capacity utilisation in the US, close to the levels seen during the recession in 1991, does not inspire confidence.  The revival in business spending will happen only in the distant future.

The US private pension system is under water by $ 300 billion and future cash flows of businesses will be needed to plug this hole. This would divert resources away from future productive investment. The only way to resolve this economic gridlock is by a long-term secular decline in the value of the dollar, as it will force Europe and Japan to resuscitate domestic demand.

The forces of globalisation are leading to a hollowing out of manufacturing and services in the developed world.

The unemployment in developed countries is bound to rise as labour intensive manufacturing and service jobs are shifted to China and India. The unemployment in the US rose in May to 6.1 per cent, the highest in nine years.

Approximately 2.6 million jobs have been lost in manufacturing since July 2000. In the early '90s as manufacturing jobs were shifted to China, the IT boom was able to absorb a portion of the workforce with some retraining. We do not have a similar boom today.

Multinationals are outsourcing manufacturing, be it in textiles or computers, to focus on their core competency. For example, retailers are focusing more on branding while high tech companies are looking more closely at research and product development.

Given all these issues, is the current market rally sustainable? Perhaps a good starting point is to look at valuation.

Andrew Smithers and Stephen Wright present the 'q' factor in their book Valuing Wall Street. 'q' is the ratio of value of companies according to the stock market and their net worth measured at replacement cost.

This is slightly different from the Tobin's 'q', which includes corporate debt.  Intuitively 'q' can be thought of as the ratio of market value to replacement value.

If the value of 'q' is greater than one, it suggests that investors value the corporation at a level exceeding the underlying value of capital assets. Similarly, the value of  'q' less than one indicates that investors are valuing the firm at less than its replacement cost.

The behaviour of 'q' is such that it reverts to mean eventually. This happens by adjustment in the numerator (market valuation) rather than through changes in corporate investment (the denominator).

The table depicts the 'q' ratio for the S&P 500 companies.  The long-term average value of  'q' is 0.63.  Given the July 7 value of 'q', around 1.0968, it indicates a long winding road downward. This suggests we are in for a prolonged period of poor returns.

The dichotomy between the expectations embedded in today's equity prices and the uncertain path for macro variables may last for some time but eventually, prices will adjust to reflect the underlying weakness in the real global economy.