Equity markets in Asia, including Japan, will remain depressed for some time. The situation in South East Asia will not improve until governments in the region slash capital spending projects and allow companies to go bankrupt. Only then will a sustainable economic recovery be possible. In the meantime there is too much risk in both equity markets and currencies in the region.

If these governments need an example of what happens when you try to manage your way gradually out of a crisis, they need only to look at Japan. Almost eight years after the equity market peaked the economy is still struggling to escape from deflationary pressures. A sustainable recovery is not guaranteed in 1998, and the equity market is unlikely to rise much above present levels.

In the US inflation keeps falling despite the economy growing rapidly and interest rates have been stable since March. But Alan Greenspan has made it clear that rates will rise if the economy keeps on growing strongly. This is set to happen in 1998. However, the peak will not be above 6.5% and only a modest sell-off in the bond market will result, with yields not rising above 7%. Any reaction in the equity market will be moderate too.

More interest rate rises are also on the way in Europe. In 1998 European real GDP will grow on average by3%, and, now that budget deficits have been cut to 3% of GDP as required by the Maastricht Treaty, fiscal policy will be easier too. By the start of 1999, when a broad EMU is expected commence, short-term interest rates across most of Europe will be around 4.5%. Bond yields will also be higher, and this will hold back equity prices, especially if European currencies against the dollar, so dampening earnings expectations.

Now that speculation about sterling joining EMU is rampant, financial markets in the UK will be influenced as much by events on the continent as by events in the UK. Base rates are likely to rise to 7.5-8% next year, but this is less important that the fact that German rates look set to go up to 4.5%.

Gilts still yield almost 100 basis points more than Bunds and this differential can narrow to just 50bp. But it is difficult to see yields in the UK falling below present levels while yields in the rest of Europe are rising. Even so, stable gilt yields will support the UK equity market, and further gains are possible from present levels, though these are unlikely to be on the scale enjoyed in recent years.

All this points to a cautious investment strategy, rather than a very defensive one. Although there are risks in some markets, the outlook is not so bad that large holdings of cash are warranted. Instead, we would recommend staying close to a benchmark weighting in equities, bonds and cash, but favouring UK assets over international assets, and especially favouring UK equities over Japanese and other Asian equity markets.

Tony Dolphin is chief economist at AMP Asset Management

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