We continue to see an extended cycle of moderate world growth and low inflation.

The global economy is out of sync: the US is leading the growth cycle and Japan, Europe and Asia are lagging. We expect the US to slow in response to tightening monetary conditions in 1998 but other major industrialised countries to pick up in response to stimulative monetary conditions, giving rise to modest acceleration in world growth.

The Federal Reserve has responded to robust US growth by tightening monetary policy to cool the economy and incipient inflation pressures. We are looking for a moderate tightening cycle, lifting official interest rates by some 75 points, which together with a strong US dollar and a negative financial markets reaction, should result in a more sustainable growth rate. However, should the economy remain more robust there is the risk of more punitive interest rate hikes and greater damage to financial markets.

The scenario whereby US financial markets are vulnerable to liquidity tightening suggests at best volatile investment returns or a run of negative returns from major markets after the past two years’ good performance.

We have become more defensive, raising cash on the premise of the US tightening cycle proceeding. Much of this has come from reducing bonds, which will price in higher real yields in a stronger growth environment, while those same conditions should underpin equity profits.

International share exposure has been reduced in line with a decision to increase cash holdings. We remain well underweight US equities. Global equity markets are likely to correct recent gains, but valuations are not generally stretched and profit cycles at relatively early stages of upswing.

We are overweight in continental Europe, where currency weakness is likely to boost profits and reap the benefits of significant restructuring. In the past quarter we also took advantage of weakness in the Japanese market to increase exposure. Exposure to Asian shares was reduced as the strong US dollar should act as a constraint.

Here in Australia there is the opportunity for equities to outperform, unless the setback in the US is more pronounced than anticipated. After 18 months of soft economic activity and profit downgrades we should see an acceleration through 1997/98. Inflation should remain in check and the Reserve Bank should not need to tighten monetary policy. With some scope for industrial company profits to surprise on the upside, and metal prices on the upswing, equities should be underpinned.