Commentary by Michael R. Sesit

Can vibrant global economic growth keep world equity markets buoyant now that the liquidity machine that fed the mergers-and-acquisitions boom seems to be fading?

The answer is yes, though investors should realise that the latest hiccup, which drove the Standard & Poor's 500 Index down 6.4 percent and the Morgan Stanley Capital International All-Country World Index down 5.8 percent between July 19 and August 9, indicates they are living on borrowed time in a maturing market.

The bull market that began in October 2002 has been built on a combination of global growth and financial engineering, itself a function of too much cheap money chasing too few assets. The hallmark of this financial innovation was the leveraged-buyout deal in which take-overs were financed by high-yield debt. The transaction made sense because corporate cash flow yields were above those on junk bonds.

Now, though, the current upheaval in the subprime-mortgage, leveraged-loan and private-equity businesses confirms that financial engineering is stumbling.

Here's how the LBO process works: "A deal gets announced; syndicated loans are made by a consortium of banks; it then takes the banks a month or two to market the loans to investors and sell them off," says Greg Jensen, co-chief investment officer at Westport, Connecticut-based Bridgewater Associates Inc., which has $165 billion under management.

The problem is that since April, banks have had difficulty unloading the loans — about $300 billion worth, Jensen figures. Other estimates are in the $200 billion-to-$300 billion range, he notes.

Now for the good news.

Although the US economy has slowed because of a weak housing market and tightening credit conditions, "upgrades in Europe and continued strength in developing economies have made up the difference," says Robert Buckland, London-based chief global equity strategist at Citigroup Inc.

The bank's economists forecast US gross domestic product to grow 2.2 percent in 2007, the 13-nation euro area to expand 2.7 percent and global GDP to grow 3.7 percent.

"The world economy is still in a low-inflation boom, driven by an enormous supply-side expansion," says Chen Zhao, head of global strategy at BCA Research Ltd. in Montreal. "This environment is inherently bullish for growth-oriented assets, and the recent financial turmoil hasn't changed this broad backdrop."

Beyond the US, growth in China and the rest of Asia is robust; a profits boom continues in Japan; and though growth has eased a bit in Europe, that weakening is from very high levels. Commodity producers are also exhibiting strong growth.

"The world economy has too much forward momentum for a bear market in stocks to take hold," Chen says. For August, BCA Research's asset-allocation model is increasing its equity weighting to 79 percent from 60 percent in July, lowering its bond weighting to 19 percent from 40 percent last month and assigning two percent to commodities.

The solid world-growth outlook supports healthy global-corporate earnings, which Buckland projects will expand about 10 percent over the next year. "This is down from 16 percent growth enjoyed in 2006, but hardly a disaster," he says.

"Just tracking earnings would suggest double-digit returns for global equities over the next 12 months," Buckland says.

In the US with 89 percent of the S&P 500 companies having reported, second-quarter earnings are up an average of 7.9 percent, compared with expectations of 3.9 percent on April 1.

"Earnings are still being upgraded for this year and next, and there is still a lot of dividend growth," says Mike Lenhoff, chief strategist at Brewin Dolphin Securities Ltd. in London.

What's more, with the MSCI All-Country World Index selling at 16.4 times trailing earnings, price-to-earnings ratios are little changed from when the current bull market began. By contrast, the index's P/E ratio reached 35 in 2000.

"The valuation excesses that brought the last bull market to an end remain absent in this bull market," Lenhoff says. Valuations have become even more attractive, compliments of the recent equity-market sell-off.

Nonetheless, the bull market has the characteristics of an aging beast. The latest decline is the second large retreat this year; previously, they occurred once a year. And the 14 percent rebound following the last setback in February and March is half the average of the previous four post-sell-off rallies.

"Volatility is rising," Buckland says. "This is symptomatic of a bull market moving into its more mature phase - not a reason to call the top, but a time to be more agile. The sell-offs will be faster, but so will the rallies."

Still, "we are at the beginning of a long, slow contraction of global liquidity, based upon a rising cost of capital, declining risk appetite and a reversal of carry trades," says David Roche, Hong Kong-based president of London financial consultants Independent Strategy.

Stock markets may rebound back to their highs. "The huge blowout in high-risk debt will not be a one-way road to hell," Roche says. But the liquidity contraction will eventually slow world economic growth "some time next year," dragging stocks lower, he says.

Interested in purchasing some insurance? Roche recommends selling short those industrial sectors and markets that stand to lose the most in a global economic slowdown. These include emerging-market debt, oil, industrial commodities, Asian emerging-market stocks and resource-based currencies such as the Australian and Canadian dollars.

Meanwhile, defensive investments include food, water, infrastructure and alternative-energy — including nuclear — assets.

Better hope these strategies work, because betting on stock markets in a slowing world economy suffering from a steady withdrawal of liquidity can prove a painful, unrewarding experience.

(Michael R. Sesit is a Bloomberg News columnist. The opinions expressed are his own.)