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Why investors may be burying their heads in the sand

U.S. investors are clicking their heels in October after spending most of September fretting about the risk of a global economic slowdown. Are happy days here again?

Define "happy." Certainly, owners of technology stocks can cheer Friday's surge in financial markets, which extended a broader rally in equities this month. Shares of Google parent company Alphabet (GOOG), Amazon (AMZN) Microsoft (MSFT) all saw sizable gains, while benchmark indexes also rose after China moved to shore up its flagging economic growth by loosening monetary policy.

But some market forecasters take a decidedly more tempered view. Economists at Deutsche Bank Securities predict in a research note that the U.S. economy is unlikely to grow much faster for 2015 than the 2.2 percent annualized rate it has averaged during the latest business cycle.

To understand why that's a concern, let's briefly hearken back to the financial crisis that gripped Asia in 1997-98. At the time, U.S. GDP was soaring upwards of 5 percent, giving Americans a cushion from the "Asian flu" that battered economies in the region. The Federal Reserve lent further support by sharply cutting interest rates.

Flash forward to today. Asia has caught another bug, and this time around U.S. economic growth is middling at best. Interest rates also continue to scrape bottom, making it harder for Fed officials to dispense any medicine if the economy starts to show symptoms of what's ailing China.

"Simply put, we do not have the same cushion between expansion and contraction now as we did during the slowdown in the emerging markets from 1997 to 1998, when we could absorb an external shock such as the one that emanated from Asia," Deutsche Bank said.

And that external shock is steaming our way, contends economist David Levy of the Jerome Levy Forecasting Center. "The global economy is in the process of entering a recession," he said bluntly in a client note, predicting a worldwide downturn in the next three to nine months.

One reason for his pessimism: China's efforts to shift its economy away from manufacturing and investment toward a consumption-driven model is much more difficult than many market participants recognize. For that rebalancing to proceed, the Chinese economy, including business profits, needs to grow, Levy said.

However, economic growth rates in the People's Republic are shrinking much faster than China's official numbers indicate. Barclays estimates that the Chinese economy grew 5.2 percent in the third quarter, well under the 6.9 percent rate of growth reported last week by Beijing, already a six-year low.

"The problem is that China has been growing so long with huge overinvestment that it needs to slash investment so much that the other profit sources cannot make up the difference, and that's before considering the widespread financial problems relating to past overinvestment," Levy said.

If he is right, investors' joy is unlikely to last.

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