If the United States economy were a hospital, its patients would run the risk of addiction to the fiscal equivalent of Demerol, the high-powered painkiller. Whether the nation can maintain the current course of treatment without severe side effects, let alone withdrawal symptoms, is a quandary facing investors who are presented with a mixed set of economic and market symptoms.

Over the past year, the government has served as white knight to the auto industry, tried to stimulate the housing industry with tax credits, and pumped untold additional billions into the financial system. Congressional legislation meanwhile has been chock-full of spending programs in an attempt to amplify the wave of hand-outs. When combined with the Federal Reserve’s asset-purchase program, the total stimulus package has amounted to almost 20% of GDP. The figure is staggering by developed-world standards.

This profligacy now seems justified by nascent economic improvement. Yet caution needs to be exercised in interpreting a handful of better-than-they-have-been statistics. The US economy is driven by the mighty consumer, and consumer spending remains feeble in the context of bloated debt levels. Moreover, unemployment nationwide is 9.7%, and substantially higher in states like Michigan and Nevada. The true level of joblessness, including discouraged and unwillingly self-employed workers, is likely even more sobering. Meanwhile, business investment remains lacklustre, despite an effective zero-interest-rate policy.

The economy is flush with Demerol. Yet what happens when the drug runs out? No one quite knows, but I suggest that the outlook is not so promising. Demerol is considered sufficiently addictive that New York State health authorities allow hospitals to administer it to a patient for only two consecutive weeks. There may be an analytical parallel here.

Demerol works quickly, setting off a “rush” at its onset and thereby creating a vicious cycle of dependence. Our economic perception has been distorted by recurring injections of the opiate. That suggests the likelihood of a nasty withdrawal period as the economy moves into fiscal detox. Officials need to figure out how to downgrade to a lesser painkiller… the economic equivalent of codeine.

Warnings of Demerol dependency may be found in the US Treasury market, with yields notching down during August. As a lifelong equity strategist, I rarely am willing to make such a capitulation, but the rapid “V”-shaped recovery suggested by the sharp gain in the S&P 500 since March is not realistic. The technicians support this view by arguing that the equity rally has been unusually thin in volume, a sign that institutional investors continue to hide—or run—in fear.

We are unlikely to see much of upward economic trajectory when the anecdotal evidence remains dreary. The State of California is even resorting to a jumble sale
of incidental government assets to help plug its budget deficit. Granted, the state has some unique taxation challenges, but California is the world’s eighth largest economy and chock full of information-age industries like entertainment and technology. Riddled by stumbling state economies, including other pivotal ones like Illinois, Florida, and Ohio, overall US activity will likely take longer to improve than suggested by Business Week’s recent prosperity-peddling cover, “The Case for Optimism.”

In this environment, our preferred asset class remains US corporate bonds. Certainly credit is not as cheap as it once was, but we are likely to see further buying opportunities. We especially target lower grade issuers, given selectively wider credit spreads, if the economy disappoints over the near-term.

The bond recommendation is admittedly pointless for our Shariah-compliant relationships because of riba prohibition. For these investors, we suggest exposure to equities influenced by Chinese growth trends. One of the surprises over recent weeks has been the strength of Asian growth in the face of frail activity elsewhere. Mid-cycle characteristics of selected investment opportunities in China, South Korea, and Singapore will afford comfort for those investors displaced by the volatility of early-cycle investments. In the complex neuro-system of global finance, China and its related growth themes may be a node worth emphasizing.

Longer term, we are enamoured with private equity, given the sharp discount in asset values we see just about everywhere. Our contrarian story in this asset class falls to Eastern Europe, where the debt overhang is scaring away conservative investors. Other players may find an allocation to South Asia to be better suited to their tastes. India survived the brunt of the global downturn because of its relatively limited exposure to merchandise trade, as well as regulatory prudence in the financial sector. Growth may reach 8% next year, making it the flavor of 2010.

Signs of Demerol dependency include a need to increase the dose to maintain its effects. Yet abruptly stopping Demerol intake is not recommended, because of an associated set of withdrawal symptoms ranging from severe anxiety to insomnia
to muscle spasms. These effects start within hours and can last for many days.

The analogy to government-stimulus spending is instructive. The US economy will likely need ongoing medical attention for some time, yet the formula for easing off public painkillers has yet to emerge. While we have not succumbed to the full-blown dark-future theory, the global investor might best let the US addiction subside, while selectively exploiting market vulnerabilities.