THE global economy is poised to return to positive growth this year, but crosswinds are fast gathering across the course to recovery, suggesting choppy waters ahead. Even as economies make further progress in their rehabilitation, 2010 is likely to be a challenging year for investors as government stimulus fades away, leaving private demand to pick up the mantle of driving activity.

In late-2009, we said greater investor caution would be warranted going into 2010, highlighting in particular, the risk of "premature" policy tightening.

Policy concerns have indeed progressed while two other risk factors have emerged: growing fiscal pressure in peripheral European countries and/or Eastern Europe; and persistent strength in the US dollar.

All three risk factors appear to be developing into real issues and may potentially prompt investors to re-evaluate aggressive risk positioning in their portfolios.

As we noted in November 2009, many investors have focused on the risk of "premature" tightening in the US, much like was the case in 1994. We, instead, had our eyes on Asia, in particular, China.

In the fourth quarter of 2009, we saw incremental policy tightening from the region’s central banks as they combated hot money flows into their economies.

We entered the new year expecting policy moves to remain just that, incremental. However, the first few weeks of the year have seen China report a near-doubling in loan growth, which subsequently prompted a swift and aggressive policy response.

The first move was a 50-basis point hike in the bank reserve requirement ratio. This was reportedly followed by more overt tightening measures.

Regional press reports recently suggested that in addition to the earlier reserve increase, banks that were most aggressive in driving lending growth in early-2010 are subject to a further increase in reserve requirements.

In addition, talk of outright lending quotas appears to be on the rise. In any case, Citi analysts now expect the reserve requirement ratio to reach as high as 18% in the coming months, up from 16% currently and beyond the pre-crisis peak of 17.5%. Higher policy rates appear to be on the horizon as well.

What is perhaps especially disconcerting is the fact that China's tightening comes just as US emergency measures announced during the height of the global credit crisis are set to expire over the next two months.

Thus, on the margin at least, Chinese and US policies are set to shift from the aggressively accommodative stance taken in early-2009 to an incrementally tightening stance earlier in 2010 than expected.

Developments on the second risk catalyst, growing fiscal pressure in Europe/Eastern Europe, likewise seem to be accelerating. As we noted in late-2009, several European governments chalked up huge deficits as well as high levels of outstanding debt as they responded to the global credit crisis.

These imbalances are now coming to bear as markets pressure governments to start addressing these shortfalls, with Greece the focal point of attention.

From a trough of 100-125 bps in mid-2009, Greek credit default swaps spreads have risen to 350 bps, well above the 200-250 bps seen in late-2008/early-2009. This indicates that markets are pricing a rising probability of default on underlying Greek sovereign debt.

Citi's interest rate analysts note that while markets have seen some large spread moves year-to-date, it is possible that "this may just be the tip of the iceberg" and EU institutions and other Euro zone members may eventually be forced to come to Greece's aid should the risk grow too meaningfully.  

Indeed, even as recovery is taking hold in many other countries in Europe and the rest of the world, Citi analysts forecast the Greek economy to contract a further 0.4% in 2010.

Moreover, while the Greek government has announced fiscal tightening plans to placate market fears, Citi analysts believe much uncertainty remains about their implementation.

They also note that greater progress on structural reform would be necessary to ensure durability of any progress made. Because of these risks, they expect Greece's outstanding government debt to rise from an already troublesome 113% of gross domestic product (GDP) in 2009 to as high as 125% of GDP in 2011.

Finally, the US dollar, following a pause after a late-2009 rally, appears to have resumed a strengthening bias. The US dollar index has risen over 2% since mid-January 2010, driven primarily by US dollar strength against the Euro.

The latest rally replicates, in only one week, nearly half the 5% rise the US dollar index seen from late-November, 2009 to the end of the year. Citi analysts expect the US dollar weakness to resume eventually.

But in the near term, the prospect for further strains on Euro zone fiscal positions, combined with recent comments from Japan's finance minister calling for a weaker Japanese yen, appear daunting for US dollar bears.

On balance, we retain a focus on the global economic recovery continuing in 2010. But developments on the three key fronts flagged up since late-2009 suggest that risks in the markets are building up as we progress through this period of transition in the global economy.

As global markets exit earnings season over the next two months (in which we do expect upside earnings surprises), the positive catalysts of upside earnings and economic growth surprise in subsequent quarters are expected to become increasingly hard to come by.

This leaves the risk-reward balance favouring a priority for risk management over a mere pursuit of reward. We continue to believe that investors should moderate expectations about potential returns available in global markets and increasingly focus on evaluating, managing and moderating risk within portfolios early in the year.  

Norman Villamin is director of wealth management, Asia-Pacific Citi. Editor's note: This commentary is dated Jan 27, 2010 and further developments may have taken place.