This article was originally published on  www.forbes.com on August 20, 2009.

Last week's data show that Germany and France emerged from recession in the second quarter of the year, while for the Eurozone as a whole, growth was only barely negative in the three months ending in June--a much better reading than consensus expectations.

In the U.K., the economy remained very weak in the second quarter, but the business surveys--sometimes a more reliable guide than the first cut of the official data--point to recovery. In the U.S., growth in industrial production in July provides evidence of the turn in the inventory cycle that is set to turn growth positive in the second half of the year.

Given the depth of the plunge in the global economy following the disorderly collapse of Lehman Brothers and the freezing up of financial markets last September, it is not a surprise to see stabilization. The Eurozone economy contracted by nearly 5% in the 12 months ending in June, while the U.S. contracted by 4%. Economies cannot shrink at that rate indefinitely.

The rally in risk assets that started in March can be justified in the context of aggressive government responses that have eased market concerns about the dangers of a second global depression. And easier financial conditions will themselves aid the recovery. But to the extent that financial markets are now pricing in a V-shaped return to business-as-normal, there is considerable room for disappointment.

Government intervention on an unprecedented scale--monetary policy, unorthodox monetary policy, direct intervention in financial markers and fiscal spending--has brought about stabilization. But this does not provide the foundations for a V-shaped return to business-as-usual.

As Bill Gross, PIMCO's co-chief investment officer, recently put it, there are three “rockets” in a cyclical recovery: The first is policy stimulus; the second is the turn in the inventory cycle, which reinforces the violence of the drop-off in activity, and then in return may exaggerate the vigor of the early stage of recovery. We are witnessing this now. The third rocket--and the crucial stage of the recovery--is the firing of income growth, consumption and investment spending. This is where the big doubt lies.

The stabilization of the data and the rally in risk assets has been brought about by huge government interventions. As the financial and household sectors have delevered, governments around the world have levered up. This raises the question over the strength of private demand growth as the impact of government interventions starts to wane. The key question in the financial sector is the extent to which this will translate into easier credit conditions for businesses and households.

The violent rise in unemployment, above 9% in the U.S. and the Eurozone, is a significant challenge to income growth, and in turn, consumption growth and top line growth for businesses. Conventionally, unemployment can be seen as a lagging indicator, but the sharp rise in unemployment in Europe and the U.S. is a significant challenge to the third rocket of sustainable recovery. For evidence, look to the weakness of July's retail sales in the U.S. and the ongoing decline in consumer confidence.

The Federal Reserve, in its statement following its meeting last week, recognized that the economy is “leveling out” but added that household spending “remains constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit.” The second-quarter earnings season, meanwhile, provided a lot more evidence of cost-cutting than of revenue growth.

In Europe, meanwhile, ongoing weakness outside Germany and France offers further cause for concern. The Spanish economy contracted by 1% quarter-on-quarter in the three months ending with June. As well as the overall impact on Eurozone growth, the combination of weak growth and rising government deficits will require painful and long-lasting adjustments in particular countries and raises the left-tail risk of default by a member country within the European monetary union.

In addition to the struggle to return to pre-crisis levels of potential growth following financial crises, the historical evidence points to the likelihood of lower potential growth as a result of the crisis over the secular outlook. Research by Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard University on financial crises since World War II in both industrial countries and emerging markets points to negative effects on housing and labor markets that last for five or six years. The well-designed policy responses may lead to a better outcome in this cycle, but we are dealing with a crisis of the global system, not just country- or region-specific problem.

Government intervention has helped to stabilize the system, but resulting bigger governments and re-regulation will push potential growth rates down over time. Changing attitudes to risk may have lasting effects on capital spending and on research and development. One particular danger is the threat of protectionist policy responses, particularly in the event of a double dip that brings into focus the extent to which domestic policy support has leaked abroad.

In this context, with markets detaching from the fundamentals, there is a strong investment case for caution on risk assets following the rally--in particular, a high quality bias, including a focus on reliable sources of income growth rather than capital gains.

For investors, the sequencing of the global recovery is key. While the sudden stop that followed the Lehman Brothers collapse affected all countries, those with better initial conditions going into the crisis--emerging-market countries with less exposure to financial leverage--should be better positioned for a sustained return to growth.

Among central banks, it is little surprise that Australian and Norwegian central banks should be sounding more confident than their industrial country peers as small, open, commodity-producing economies with exposure to faster growth in emerging markets. For the Federal Reserve, Bank of England and, to a lesser extent, the European Central Bank, however, markets are pricing in fairly aggressive rate-tightening cycles in 2010 that are unlikely to be realized.

Andrew Balls leads the European investment team at PIMCO.