The underlying economic background for world financial markets remains benign. Whilst interest rates have probably bottomed, for the most part we at the Prudential believe that the rises required will be modest and gradual.

There are two clouds on the horizon for pension funds. The first relates to the issue of imminent European Monetary Union (EMU). We believe that the path to EMU will be far from smooth. This may provoke further instability in European exchange rates, interest rates and financial markets over the next two years.

The other difficulty is the valuation of markets themselves. Some bond markets are almost as expensive now as at the end of the 1993 bull market, which is especially true of peripheral European bond markets, apparently rising on a wave of EMU-phoria.

The valuation of equity markets is less unattractive, but few markets look cheap and some, notably the US and Switzerland, are particularly expensive. Wall Street’s recent appreciation is not justified. So, we prefer the European and Japanese markets.

We are equally cautious to some extent about the UK markets. The broad economic background is positive - the UK economy should see good growth of in excess of 3% next year and we agree with the Chancellor that inflation should not pose much of a problem. Yet consumer spending could grow more quickly than this. In spite of what is likely to be a very good background for corporate profits in the UK, rising interest rates and the uncertainty associated with the general election imply a bumpy issue for UK equities, with total returns likely to be below 1996.

Gilts look good value in an international context although they will find it difficult to make progress when international yields are rising. The property market, on the other hand, where yields are relatively high and where rents are starting to show some growth, should prove to be one of the better performing assets of 1997.

Our investment policy is currently extremely cautious. Balanced pension funds are modestly short of both equities and bonds, with correspondingly long positions in cash and property. Within equities, funds are underweight particularly in the US and Swiss markets. On the other hand, slightly overweight positions are held in the US and Japanese bond markets.

Andrew Gillies is a director of Prudential Portfolio Managers