Warning lights flash on global economy's dashboard

— -- For the past year, as the United States wallowed in financial crisis, the economies of Europe and Japan continued to grow. No longer.

Now, both of these key trading partners are shrinking, imperiling the strongest remaining pillar of the U.S. economy and complicating prospects for an early return to stability. The worrisome prospect of a global recession — last seen in the early 1990s — is emerging as a realistic danger.

"The growth situation has gotten markedly worse outside the United States recently. … We're probably looking at a year and a half of subpar growth" for Japan, Europe and the U.S., said Kenneth Rogoff, former chief economist for the International Monetary Fund.

Just how bad is it out there? For all its myriad weaknesses — wounded financial institutions, depressed consumers and sinking home prices — the U.S. was the best-performing economy in the industrialized world in the second quarter, according to the Paris-based Organisation for Economic Co-operation and Development. The U.S. grew at an annualized rate of 3.3% in the quarter ended June 30, the Commerce Department said last week, while Europe and Japan both posted negative numbers.

"The Eurozone and Japanese economies are on the verge of recession," French investment bank Societe Generale said last week in a research note.

After almost two decades of relentless globalization, what happens abroad is increasingly central to the health of the U.S. economy. In 1980, foreign transactions of all kinds — trade of goods and services as well as investment earnings — equaled about one-quarter of the economy. In 2006, the most recent figure available, they reached nearly 39% of gross domestic product, according to the Commerce Department's Bureau of Economic Analysis.

From lawn mowers to syringes, American factories in recent months have been sending an increasing volume of goods to foreign customers. Exports of manufactured goods and agricultural products were responsible for almost all of the surprisingly solid second-quarter number.

The U.S. uptick also was undoubtedly helped by tax rebates that put more than $93.4 billion into consumers' hands starting in May. With most of that money spent, and the index of leading economic indicators pointing down, analysts say the current quarter is unlikely to be as good. Outside the U.S., skies are darker, raising questions about how long the export boom can continue.

"This will be one of those synchronized global slowdowns. … There will be a lot of pain around the world," says Sung Won Sohn, a former White House economist now teaching at California State University.

Getting softer

European economies are soft and getting softer. Germany, the continent's bellwether, appears headed toward outright recession. German executives are more pessimistic about the next six months than at any time since early 1993, according to the Munich-based Ifo Institute for Economic Research. Its business climate index has fallen for three consecutive months.

In Japan, producer prices rose at the fastest pace since 1981 even as the economy contracted in the second quarter. Bank of Japan Governor Masaaki Shirakawa reassured a business group recently that the economy is unlikely to return to the prolonged stagnation of the 1990s' "lost decade." But he cautioned, "Growth will likely remain sluggish for the time being."

Warning lights are flashing all over the dashboard of the global economy. Even China is slowing, though from feverish double-digit growth rates to a still-robust 8% or so. World trade volume fell in June for the second consecutive month and turned in the worst quarterly performance since the fourth quarter of 2001, according to CPB Netherlands Bureau for Economic Policy Analysis, an independent firm.

Despite that stagnation, many U.S. companies that have prospered in recent years thanks to surging overseas orders say they expect good times to continue. For example, 68% of Hewlett-Packard's $28 billion in revenue for the quarter ended July 31 came from outside the U.S. HP told analysts earlier this month that it expects sales of more than $30 billion this quarter.

A major catalyst for the jump in exports has been the dollar's 25% decline against the euro the past two years. The currency's fall also makes sales earned in foreign currency more valuable when they are converted back to dollars, helping corporations' bottom lines. Emerson, a St. Louis-based manufacturer of automated systems and power gear, says foreign exchange movements accounted for 5 percentage points of the 14% rise in its third-quarter sales.

The greenback's recent rally — it's up about 8% since late July — will weaken one sales prop in future quarters. But currency shifts take time to affect new orders, because many sales are governed by long-term contracts. Despite the dollar's recent move, exports likely will remain strong for three or four additional quarters, according to forecasts by the Peterson Institute for International Economics.

Overdone fears?

Some analysts say fears of a global downdraft are overdone. They point to continued robust growth in developing economies in Asia and Latin America as well as the gradual rebuilding of bank balance sheets in the U.S. as supporting a less apocalyptic view. "I've been traveling through Asia all August from Karachi to Taipei. There is not a feeling that everything has gone wrong (or) that all parts of the global economy are in ever-worse shape," says Norbert Walter, chief economist of Deutsche Bank.

Emerging markets, once the first places to feel an economic chill, remain hot. Continued expansion in developing countries such as China, India and Brazil mean companies from tractor maker John Deere to medical devices producer Covidien expect continued strong financial results. At Deere, based in Moline, Ill., 43% of its more than $7 billion in third-quarter sales came from outside North America, up from 30% five years ago.

The company's hottest markets include the former Soviet empire, where Deere logged more than $1 billion in sales last year, and Latin America. The boom in global food prices has prompted farmers around the world to open their wallets for the company's array of tractors and combines. Demand is so strong that customers wanting one of Deere's series 9000 tractors must wait until September 2009 to take delivery.

"The broader global economic environment remains quite favorable for a company like ours," Susan Karlix, the company's investor relations manager, said on an Aug. 13 conference call.

To meet the surging demand, Deere last week announced a $97 million expansion of its Waterloo, Iowa, and Coffeyville, Kan., facilities. That followed a $90 million investment in the plant announced in February. About one out of every three tractors made in the Waterloo plant are shipped outside of the U.S. and Canada, the company says.

The spread of affluence into pockets of the developing world has created openings for products linked to the traditional suburban lifestyle. Toro, maker of lawn mowers and irrigation systems, has increased international sales to almost 30% of total revenue vs. 20% four years ago, says John Wright, director of investor relations for the Bloomington, Minn.-based company.

Golf courses in South Korea and Dubai. Parks and athletic fields in China. All have spurred demand for the company's products. "As countries develop, they put in more bridges and roads, sure. But they also want more grass and better-looking grass," Wright said.

Even as some manufacturers worry that slowing foreign economies will pinch sales, others occupy niches expected to ride out any downturn. Covidien has seen steady sales growth the past three years, most of it outside the U.S., says CEO Richard Meelia.

The company doesn't expect to emerge unscathed from a global downdraft. But aging populations that demand more health care mean the company's outlook is positive. "Basic demand doesn't really change from cycle to cycle. … It's not like industrial businesses," said Meelia.

Higher shipping costs

Many U.S. multinationals, however, are bracing for the impact of higher transport and materials costs. Skyrocketing oil prices have increased transoceanic shipping costs 64% since 2005 and also have raised the cost of producing many plastics-based products. In 2009, higher costs for resins used to make syringes and plastic collection tubs for used needles will cost Covidien up to $50 million, Meelia says.

At Deere, about half of this year's higher costs are expected to hit in the fourth quarter. The annual bill could reach $475 million and put pressure on profit margins, the company said.

A bigger worry is the medium-term outlook for the emerging markets that have become the global economy's chief bright spot. With Europe, Japan and the U.S. expected to remain weak into 2009, multinationals' prospects may hinge on developing nations.

So far, they've held up well. But inflation is bubbling in several countries, including in the Middle East and East Asia. Nervous central bankers have held off on raising interest rates to slow their economies, fearing such moves could be ill-timed if the global financial crisis worsens. Growth-choking rate increases in countries such as Malaysia, however, can't be postponed indefinitely.

There are already signs of emerging weakness. In August, three nations — Taiwan, Singapore and the Philippines — trimmed their 2008 growth forecasts to take into account the spreading global slowdown.