On the economic front, though, the situation continues to get better as the global economy recovers from the sharp and short recession of 2009.  Emerging economies had an outstanding year of growth in 2010 and now the developed economies of the world, particularly the US, Europe and Japan, are also starting to see their growth rates pick up, despite the removal of much of the stimulus from government spending that was put into place during the downturn.  In fact, the International Monetary Fund (IMF) raised its forecast for global economic growth this year, reflecting stronger U.S. output based on tax-cut extensions, while emerging nations lead the recovery. Expansion in 2011 is projected to reach 4.5 percent, the IMF said in comments posted on the fund’s website.  While a faster-than-expected second half of 2010 helped put the world on a stronger foothold, the IMF warned that risks to its predictions remain “elevated.”  It pressed euro- region governments to build a comprehensive plan to prevent sovereign-debt “financial stresses” from spreading out to other countries and urged emerging countries to closely watch the rise of asset price bubbles as inflation risks increase.   “In advanced economies, activity has moderated less than expected, but growth remains subdued,” the IMF said in the report. The institution said that in “many emerging economies, activity remains buoyant, inflation pressures are emerging, and there are now signs of overheating, driven in part by strong capital inflows.”   The IMF also said that financial conditions have improved, with equity markets and commodity prices rising, but it warned that global financial stability is not assured yet, with the interaction between banking and sovereign credit risks in the 17-country euro region remaining “a critical factor.”   The IMF’s estimates are more optimistic than those of private forecasters, who expect global growth of 4.2 percent this year.  The IMF also raised its 2012 global growth estimate to 5 percent, the fastest pace since 2007 and up from the 4.8% rate forecast last October.

One risk for markets is how long we will see this exceptionally low level of interest rates, which have provided a huge support for rising stock and commodity prices.  One of the bigger risks to interest rates would be the emergence of inflationary pressures again at some point.  Following the economic collapse in 2008, there was a lot of excess capacity in the global economy, meaning that there was very little upward pricing pressure.  In fact the bigger worry was that deflation, not inflation, was a bigger risk for the global economy.   That is why central banks felt comfortable pushing interest rates as low as they did, knowing that economic growth would have to come back a long way before capacity got strained again and inflation pressures came back.  Although inflation has yet to become an issue in most of the advanced economies of the world, price pressures have started to increase in the emerging economies of the world, as shown in the chart below.  Rising inflation levels in emerging economies is one reason why we have seen interest rates going higher again in countries such as China and India, as well as in more developed markets like Australia.

Rising inflation in China and India are partially a result of the strong growth seen in those economies in the past year but are also due to the fact that food prices have risen so sharply.  Food costs are a much higher portion of a family’s budget in emerging economies (as much as 40-50%) versus the advanced economies, where it tends to be around 6-8% of the total budget.  The sharp rise in grain, meat, oil, processing and transportation costs over the past year have contributed to significantly higher food inflation which, in turn, has driven up the consumer price indices in the emerging markets.  China’s CPI hit a peak of over 5% in late 2010, backing off slightly to a 4.6% in December.  Higher inflation necessitates higher levels of interest rates to control those pressures.  This presents one of the risks to the bull market in financial assets if these inflationary pressures start to show up in the US numbers.  The extraordinarily low level of interest rates has really forced a lot of money into stocks due both to positive economic impact of low rates as well as how it improves the relative attractiveness of stock dividend yields.  If interest rates need to start rising to control inflationary pressures which might arise in North America, then the bull market in stocks and commodities could ‘hit a wall.’  Perhaps that is what the strength in gold prices is trying to tell us since gold tends to be positively correlated with higher levels of inflation.  For now, however, inflationary pressures are muted here.

Although inflation has been running higher in the emerging economies, growth has also been much stronger in those economies, particularly spending growth.   As the emerging economies migrate from agriculturally-based to industrially-based, people have been increasing their spending on technology products, branded consumer products, household goods and value-added food products.  As shown in the chart below, retail sales have increased by almost 60% since the beginning of 2007 versus growth of less than 5% in the advanced economies.  Interestingly as well, growth only ‘flattened out’ for a period of about six months in the emerging economies during the recession as opposed to the decline of over 5% seen in the advanced economies.  This is a trend that we expect to remain in place for many years to come and suggests that growth will continue to be stronger outside of North America, even if they have to deal with periodic levels of higher inflation.  Ongoing economic strength in the emerging economies will put a stronger base under world economic growth, particularly as the emerging economies become a large part of the total.

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