Article by WSJ

And you had such potential!

Forecasters talk about the economy the way frustrated parents might about an adult son living in the basement and working at a dead end job. Barring a wave of skilled immigration or technological breakthroughs, the economy’s potential growth just isn’t what it used to be. But investors and companies still act like it is—a dangerous assumption.

The U.S. exited the worst downturn since The Great Depression a decade ago. Growth since then has been nothing to write home about, though, with gross domestic product expanding at an average annual rate of 2.3%. That compares with 3% in the 10 years prior to the recession -- a big difference. And in the 1990s GDP grew an average of 3.3% annually.

In the future, economic growth is widely expected to be slower still. One reason why is that population growth is slipping so the pool of available workers isn’t expanding as fast as it used to. The other is that improvement in productivity—how much workers produce per hour, on average—has slowed markedly since the early 2000s. Projections released by Federal Reserve policymakers this past week centered on a forecast for GDP to grow an inflation-adjusted 1.9% over the long run. That jibes with Congressional Budget Office and many private economists’ forecasts that potential growth — the economy’s long-run sustainable pace — has slipped to about 2%.

To low potential growth add low inflation and it looks difficult for companies to generate profit gains that come close to the pace to which we have become accustomed. Making things worse, some of the earnings-boosting levers companies have turned to in the past have been used up.

With labor’s share of U.S. income near its lowest levels since the 1940s, for example, it may be difficult to expand profit margins by giving workers an even slimmer share of sales. Nor, with a trillion dollar budget deficit, does another corporate tax cut like the one that pushed after-tax earnings higher last year appear to be feasible. Meanwhile estimates of potential growth outside of the U.S. also have slipped, making it difficult for companies to compensate for lackluster sales at home.

Yet surveys suggest investors are still counting on companies delivering stellar growth. Public pension funds, which in recent years have invested about half their money in stocks with the remainder allocated to a mix of bonds and alternative assets, assume returns of 7.25% a year, according to a National Association of State Retirement Administrators survey. U.S. investment professionals polled by Natixis view long-term return expectations of 6.3% excluding inflation (so tack on a couple more percentage points for nominal figures) as reasonable. Individual investors polled by Natixis are the most bullish, expecting 10.9% excluding inflation.

It all seems like a recipe for disappointment—one in which investors will need to sharply lower their expectations for where stocks are going. State and local governments might have to add a substantial amount of taxpayer money to pension-fund coffers to meet obligations. And Americans might need to put more money into their retirement accounts or accept far less comfortable golden years.

A hidden danger is what companies might do in order to meet these unrealistic expectations when faced with the alternative of angry shareholders. They might undertake risky projects or acquisitions in order to hit their growth bogeys, says John Graham, an economist at Duke University’s Fuqua School of Business. Such actions can pay off when they work out, but also come with a higher probability of failure. Companies also could take on actions that temporarily boost growth, such as offering sales incentives, that make them worse off in the long run.

Or they might take on more financial risk, such as financing more of their operations through debt in order to boost earnings per share. They also might issue debt in order to buy back stock, juicing investor returns but boosting risk if business conditions falter.

Finally, some companies might even use less legitimate actions to create an illusion of growth. Indeed, research conducted by Imperial College of London professor Yuri Mishina and co-authors Bernadine Johnson Dykes, Emily Block and Timothy Pollock found that, when investor expectations are high, companies are more apt to engage in illegal activity.

The best option might be for companies to be frank with investors, and let them know the outlook for growth really isn’t what it used to be. Unfortunately, that kind of honesty might not sit very well with investors.