• Economic recovery is under way, based on increased demand as a result of federal monetary and fiscal stimulus, growing world trade, and new capital spending.
• Higher income and wealthier consumers are beginning to spend again, but we are waiting for middle- and lower-income Americans to recover.
• Housing activity has stopped deteriorating as rapidly as in the recent past and could contribute to economic recovery.
• We are in a new part of the investment cycle: Interest rates are rising modestly, value stocks are outperforming and corporate and high-yield bonds may be peaking. Individual stock and sector-selection are more important now as the broad stock market rally seems to be coming to an end, with returns concentrating in fewer areas.
• Watch for negative direct real estate returns to level out.

The spectacular stock market rally, which began just over a year ago, paused in January and February, but came roaring back in March to produce robust returns for the first quarter of 2010. Investors were correctly anticipating the return of economic growth, fueled by federal monetary and fiscal stimulus. The market was right, but the investment focus began to change in the first quarter.

Economic growth is continuing, but at a slower pace than at the end of 2009, and interest rates are beginning to rise. As a result, positive returns have begun to concentrate in a smaller percentage of stocks, so investors won't be able to rely in 2010, as they did in 2009, on a broad equity market rally. Value and smaller stocks, as well as REITS, outpaced large-cap growth stocks in the first quarter and individual stock and sector selection may play a more important role as the year unfolds. Similarly, rising long-term interest rates have dampened fixed-income returns, except among high-yield and emerging market bonds. But commercial real estate returns, which dropped dramatically in 2009, fell at a lower rate in early 2010 and may show some signs of life before the year is out.

Here are four key reasons to be cautiously optimistic about the economy and optimistically cautious about the markets – plus some investment opportunities to consider in the year ahead.

1. Corporate profits and inventories: rising
During 2009, corporations responded to the financial crisis and economic downturn by dramatically reducing their workforces, capital investment and R&D spending. With lower expenses, companies could take advantage of the positive economic effects of monetary and fiscal policy in the form of a striking reduction in interest rates, rapid increase in the money supply, government purchases of distressed securities and a ramp-up in federal spending/tax cuts. With further help from a steep yield curve (characterized by long-term interest rates significantly higher than short-term interest rates), low inflation and a weak dollar, corporate profitability began to stabilize and then increase.

As corporate profits began to rise in tandem with rising nominal (not inflation-adjusted) gross domestic product (GDP), firms began to increase production during 4Q2009 and 1Q2010. This added to inventories, which had an immediate effect on U.S. economic growth, accounting for half of the nearly 6% annualized growth in GDP in 4Q2009 and a substantial portion of what we expect to be about 3% growth in 1Q2010. If the consumer responds positively by purchasing these additional goods, then eventually the need for additional labor and capital spending will rise, creating the conditions that can replace federal stimulus as the driver of economic growth.

2. Consumer spending: waiting for middle-income Americans to step up
Recent figures indicate a rise in consumer spending, but most of that is occurring among higher-income and wealthier households, who have experienced at least a partial recovery in their net worth. Over the past two years, real consumer spending declined by the largest percentage recorded since the end of World War II. Consumers, unsurprisingly, stopped spending in response to the financial crisis as their access to credit dried up and household net worth declined due to falling house and stock prices.

Workers who lost jobs had a hard time finding new ones, and household incomes declined (real incomes have been declining since 2000). Although the rate and length of unemployment are expected to remain high, some leading indicators are rising. For the first time since 2007, more jobs were added than lost in March. Temporary employment hiring and employment listings are both up and initial unemployment claims peaked three quarters ago. Better employment prospects, when they appear, will help to stabilize incomes, consumer expectations, and eventually consumer spending. The critical factor will be the effect on middle- and lower-income consumers. If their prospects improve and their spending picks up, that will have a positive impact on GDP.

3. Housing recovery: fits and starts
Over the last three years, residential housing suffered its worst downturn ever. Housing starts dropped from a 2.2 million annualized rate at the start of 2006 to less than 0.5 million rate at the start of 2009 and prices plummeted. Over the past half year, home prices in some areas have begun to stabilize, an index of home affordability reached an all-time high, and sales of existing homes have finally begun to pick up. The large number of homes either in some stage of foreclosure, owned by lenders, or owned by people who have taken their homes off the market will all keep a lid on home prices over the coming years, but these conditions are well known and should not continue to push prices down significantly.

4. World Trade: U.S. exports rising
Economic and market recovery is under way around the world. Leading economic indicators for most economies (as reported by the Organization for Economic Co-Operation and Development) have been rising since late 2009, with growth particularly robust in most of Asia and parts of Latin America. As in the United States., the recovery is linked to government stimulus and corporate inventory replenishment. And now we're starting to see a big increase in global trade. For U.S. exporters, a weaker dollar and lower labor costs are already showing up in increased exports and a better overall U.S. account balance. Trade will be another positive to the recovery in U.S. GDP.

What are the risks to economic and market recovery?

Perhaps the biggest risk to the U.S. economy and financial markets is the inability or unwillingness of the domestic financial sector to provide capital to the private sector, including firms and consumers. Although bank lending and consumer borrowing continue to decline, markets for corporate investment-grade debt, high-yield bonds and leveraged loans have experienced a recovery. At the end of past financial recessions, these indicators signaled a reopening in bank lending.

Another driver of a recovery in bank lending is the steep yield curve, which provides incentives for financial firms to lend long-term. The federal government holds the key to a full financial system recovery. The Fed will need to choose the right time to raise short-term interest rates and to begin selling the securities on its balance sheet. The federal government will need to gauge how much additional spending stimulus is needed to create jobs and sustain any nascent recovery. Too soon or too late, too little or too much, could either squash economic recovery or eventually lead to increased inflation.

Another risk to recovery is the very low growth in wages. While this is likely a positive factor in driving future labor demand, the economy still faces the risk that household incomes will continue to decline. If so, then the expected recovery in consumer spending by middle-income Americans may not appear.

What can an investor do?
In 2009, it was hard to find an asset class that didn't do well, with the striking exceptions of U.S. Treasuries and direct commercial real estate. In the first quarter of 2010, equities and, to a lesser extent, corporate bonds continued to perform well. It is hard to find evidence that the equity rally can continue at its previous pace. Instead we are likely to see more volatility and differential returns. In that case, individual security and sector-picking will be more important at this point of the investment cycle.

Up to this quarter, many sectors benefited from a decline in interest rates or from operating leverage — particularly financials, autos, retailers and materials. In early 2010, we are experiencing a sea change, where asset classes and companies that aren't sensitive to rising rates are doing well, especially those that benefit most from rising revenues. On the stock front, value stocks are outperforming, and sectors such as semiconductors, software, capital goods, biotech and transportation may gain strength.

On the fixed-income side, corporate and high-yield bonds outperformed in the first quarter, but they could see more limited gains in the rest of the year. In contrast, short-duration bonds and commercial mortgage-backed securities could take a leadership position. On the real estate side, real estate investment trusts (REIT) rose in the first quarter and could continue to their current positive trend, while direct real estate might see signs of life based on more limited declines in property values in the last quarter of 2009.