For the past few years, the consistent outperformance of equities over other asset classes has made an overweight position in equities a prerequisite for good performance. The events of the third quarter of 1998 asked some difficult questions of equity markets, however, and investors around the world moved down the risk curve into the relative safety of bonds or cash. Although western equity markets have bounced back in no uncertain terms during the past few weeks, many of the problems that originally brought about August's crashes remain unresolved. The timing and rationale of any prospective return to equities are therefore among the problems taxing asset allocation teams across the City of London at present. And investors will increasingly need to have the consequences of European Monetary Union in mind when considering European weightings.

Whilst one might argue that Emu will make the member countries as a bloc more competitive in the world economy, and that the resulting shift in prosperity and competitive advantage might have long-term implications for global asset allocation, in the short term, at least, Emu is purely a Europe ex-UK event. The consequences from a UK investor's point of view come in two waves. The first occured with the transition to the euro, when all cross-currency risk within the 11 members disappeared. As the currency and legislative barriers between markets dissolve, competition will inevitably become a more cross-border phenomenon. This makes the analysis of sectors within individual European markets increasingly futile; rather, fund management houses need to take a pan-European view to understand their markets fully.

We have spent the past 18 months preparing our investment division for Emu. In 1997, we established a pan-European desk and have since started to analyse some sectors on a pan-European basis. We allocate assets to Europe excluding the UK as an area, rather than to individual countries. Our European fund managers are then free to move assets between countries and to adjust sector and stock weightings as they see fit. The homogenisation of European markets will be gradual, with different countries remaining at different stages of the economic cycle for some years, and this will clearly make for inefficiencies and anomalies. Part of the fund manager's job is therefore to exploit these anomalies in the short term but make sure his portfolios are adjusted to take advantage of the shifting landscape in the longer term. Some fund management companies will find themselves unready for the advent of Emu. Because of the considerable cost of training fund managers and altering computer systems, pension fund trustees would be advised to check what steps investment houses have taken to ready their business for the impact of Emu.

The second, more fundamental wave of changes from the UK investor's point of view will come if and when the UK joins. Consensus opinion suggests that the UK will join and that the government would prefer a joining date of 2002. Significant economic repercussions are likely in the run-up to membership. Some analysts believe the government will try to engineer a recession to encourage the still sceptical UK electorate to enter a comparatively prosperous Europe. Even ignoring these repercussions, however, our entry will have serious consequences for UK investors. Benchmarks and pensions legislation will eventually be changed and these changes will have a knock-on effect on institutional mandates. It is difficult to predict the nature of the changes and virtually impossible to guess the timing, which means that fund managers will have to keep a close eye on developments.

The second wave of changes outlined above will have a direct effect on the UK. In the interim, the UK and Europe both feature among our preferred equity markets, the former because of continued merger and acquisition activity and attractive valuations and the latter because of widespread restructuring and better growth prospects. Elsewhere in the equity universe we favour the US, where decisive interest rate action on the part of the Federal Reserve has helped to restore investor confidence. In the short term, however, the increased potential downside to earnings resulting from the problems in Japan and the Far East make a wholesale return to equities a risky strategy.

Our balanced portfolios are overweight equities, but our biggest overweight position is in bonds. Moreover, we would look to move further overweight here if equity markets post any more big upward moves, although liquidity arguments mean that it is dangerous to underweight equities.

Asset allocation professionals have certainly earned their money in 1998 and the continuing fallout from this autumn's events, coupled with the effects of Emu, look set to make 1999 equally testing.

David Kiddie is head of pan-European equities at Hill Samuel Asset Management in London