Where next for the global recovery? 

To merely say that the world economy is much better than it was just 12 months ago would be to greatly understate how far we’ve come in stabilizing the global financial system. Policymakers constructed aggressive, unconventional and often controversial programs with longer term implications but palpable near-term results.

Investors, however, remain skeptical, keeping $3.3 trillion in money market funds and purchasing more than $400 billion in domestic high grade bond funds during the year. And why not? After all, short-term interest rates can’t go lower, and budget deficits already approach unsustainable levels. Weakness in the U.S. dollar and an extreme rally in the price of gold have only heightened concerns. We naturally ask how, when and whether economic life-support policies should be removed, and whether the economy is ready to proceed without them.

For all the upward revisions to growth forecasts, consensus expectations are that the U.S. Gross Domestic Product will grow only 2.71 percent in 2010, with even slower growth in Europe and Japan. Given that the U.S. economy shrunk about 3.8 percent from peak to trough and only began recovering in the third quarter of 2009, we may not return to pre-recession levels until the middle of 2010.

Fortunately, the business cycle still exists and corporate profits are improving. A profit-led recovery foreshadows renewed business investment and hiring, although both still lag. Companies slashed employment during the recession, probably eliminating even more jobs than the contraction warranted. Jobless claims in the U.S. have been trending lower since the beginning of March, and leading indicators for full-time employment in the U.S. suggest that positive job growth is likely early in 2010.

The economic and psychological impact of the improving jobs picture should help drive private consumption at the same time that public spending further props up total output.

A return to job creation may be the impetus policymakers need to embark on the long path back to “normal.” Central bankers will surely breathe more easily as interest rates and balance sheets retreat from crisis formations. Statements from the European Central Bank sound increasingly hawkish and recent Fed minutes suggest a growing desire to end the U.S. zero interest rate policy. Central banks will likely raise rates in the second half of the year, but with ample warning for the markets. Investors should nonetheless be cautious on interest rate risk.

For the developed world, 2010 will be a “transition” year—the middle of the growth phase between recovery and expansion. The pace of the rally in the broad equity markets is almost certain to moderate, with higher quality and possibly more defensive investments returning to the fore. Investors should recognize that the over 60 percent rally since March 2009 already prices in the stock markets’ anticipation of foreseen economic growth. A slower, unlevered growth environment rewards investors who compound dependable income streams, including investments in dividend-paying companies and corporate and municipal bonds.

The renewed growth cycle promises slower growth across most corners of the globe, but with emerging markets generally growing faster than the more advanced economies. Although the recent crisis reminded us that global shocks will still jolt emerging market economies, it also demonstrated that the increasingly domestic-oriented economies are better positioned than in the recent past to absorb tremors emanating from the developed world. While concern is already growing about a new bubble in emerging markets, asset prices remain within reason and inflows into the regions are moderate compared to past cycles. Moreover, certain emerging markets are running tighter monetary policy than much of the developed world.

The current decade has not been short of surprises and the coming decade is sure to include its fair share of economic, geopolitical and natural challenges. Looking to 2010, the banking system is better capitalized and the U.S. housing market has shown signs of stabilization. Global asset markets have rallied and every major economy in the world is poised to grow in the coming year.