Despite a very positive start to the year for global financial markets, we remain broadly optimistic about the outlook. The speed of recovery from the Asian crisis last autumn suggests some degree of consolidation over coming months, but a longer period still provides grounds for optimism.

We see no reason to change our belief in ongoing disinflation. Our forecasts see further declines in long yields as investors are attracted by these high real rates, with our preferred market of US Treasuries seeing yields falling towards 5% into next year. We do not expect any Fed tightening of short rates, believing the rise in real yields and in the dollar will achieve much of the desired decceleration in economic activity. Equally, in our other preferred bond market, the UK, we think short rates have peaked and although there will be no early decline from current levels, this will not prevent further falls in long yields.

Our positive view on global bond markets underpins our enthusiasm for equities, for although equities have outperformed bonds during the post-Asia rally, relative valuations are not out of line with long-run averages. Our modest return expectations from Wall Street mean we see broadly comparable returns between US equities and bonds, so our allocation for global balanced funds remains close to neutral between equities and bonds. In the US we are pleased to note that expectations for corporate profits growth have been reduced to more realistic levels. There may still be stock-specific shocks, but the threat to the market from over-optimistic expectations is greatly diminished.

In Asia itself, whilst we have shared the financial markets' positive reaction to signs of economic reform, notably in Korea, we remain unconvinced that smaller Asian economies are yet out of the woods. Debts may have been rolled over, but little has been written off, whilst the scale of equity issuance needed to recapitalise the banking system still dwarfs that seen to date. Corporate bankruptcies or restructuring have been modest in comparison to the likely scale required, so not only does further economic hardship lie ahead but with it will come the risk of social unrest and a lessening of enthusiasm for economic reform. Within our emerging market portfolios we have been sellers into the first quarter rally in these markets, continuing to prefer the markets of eastern Europe and Latin America to those of Asia. Hong Kong remains an exception where we have been happy to add to positions during bad days this year. In Japan, by contrast, we still see insufficient sign of radical policy response to alleviate the current situation and we remain significantly underweight.

Europe remains our favoured equity area and whilst our overweighing here has served well this year we think it too early to consider a reduction. Activity is clearly accelerating even within the core countries now, whilst we see little prospect of any early move to raise short rates. Corporate profit margins remain below peaks achieved during the last cycle and with corporate restructuring to improve productivity and take advantage of the opportunities created by the single currency still ongoing, we would expect margins to peak at higher levels this cycle than last. Meanwhile the rising savings flows into equity markets fuel a rerating of equities justified by this corporate profits outlook and moreover, these flows show no sign of easing. Our enthusiasm for European equities remains a cornerstone of our positive outlook for global equity markets.

Richard Buxton is divisional director of Baring Asset Management in London

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