It was only two months ago that the Federal Reserve decided not to increase rates for the first time in 18 meetings but the markets have already moved onto the next phase of US monetary policy.

The stock markets have edged up to new highs as the chances of a soft landing in the US economy have increased. In the case of the Dow Jones, the index is very close to a new all time high, though this is slightly misleading as it is calculated on a price weighted basis and consists of just 30 names. The S&P 500 is at a 5 year high but remains some 12% below the highs reached in 2000. The recent strength is in line with our expectations and justifies our strategy of sticking with equities during the sell off in May/June. Further we remain optimistic for the final quarter due to attractive valuations, strong balance sheets and merger/acquisition activity.

We continue to find excellent opportunities within equities and especially in US large caps where valuations have compressed and so we have decided to increase our exposure to the US. For much the same reason we have taken our European weighting to overweight and this now makes our regional allocations more neutral when compared to the MSCI World index. Having adopted a significant bias towards the East (Asia/Japan/Emerging) for some time we now feel less confident about these markets relative to the US and Europe. Therefore we have taken profits in Asia, cut Japan from neutral to underweight and reversed the purchase of Emerging markets we made in June.

Finally, bond yields have tumbled in reaction to the scenario described and have wiped out the emergence of value. In our bond portfolios, having profited from shifting duration longer earlier in the year, we are now moving back to a more defensive posture.

After a roller coaster ride over recent weeks, the MSCI World index ended almost exactly flat over the month of June. This hides some of the most volatile periods we have seen in equities for some time and reflects investor uncertainty on many fronts including inflation, interest rates, currencies, commodities and economic growth. It is natural that all of these factors occupy the minds of market operators and there is some truth in the old saying that 'markets climb a wall of worry'. We have our own views on all these issues but like everyone else we have to pay attention to the new data releases which hit the screens on a daily basis. So like the Federal Reserve (Fed) our views are 'data-dependent'. For this reason, it is fairly likely that volatility will continue to move a little higher going forward as economic data is published - no doubt giving conflicting signals from one week to the next. The Fed increased rates for a 17th consecutive time at the end of June which led to a strong rally in equity markets. The 'explanation' for this was a softening of the Fed's language but in fact there was very little change. It is much more likely that the markets got a little ahead of themselves in expecting the 18th rise in rates in August - this is now a 50:50 chance. This might all sound like a risky time to be exposed to equities. It is probably fair to say that risks have increased for the asset class but we remain positive for the rest of this year and (data depending) believe that there is more to go for in this market cycle.

The Financial Times reported last week that the first half of 2006 has been the strongest ever six month period of merger and acquisition (M&A) activity, even surpassing the heady days of the dotcom boom.

Going back to interest rates, interest rates in the US have risen from 1% to 5.25%. Providing inflation doesn't move up significantly from current levels, it is reasonable to expect the Fed to pause in the near future. Indeed we would not be surprised to see more evidence of a slower pace of growth in the US over the 2nd half of 2006 as the combined headwinds of higher gasoline prices and higher interest rates start to make an impact. This would give the Fed scope to 'pause' its tightening in order to see to what extent the medicine works.

The main driver of the equity and bond markets at the moment is expectations for interest rates. Recent data has in the main indicated that the US economy continues to grow at a very respectable pace, leading to expectations of further tightening moves by the Federal Reserve, and this has been holding back the US market to a degree. The strength of recent data has given us cause to consider our previous view that rates would level out around 5%. There are indeed many commentators who expect rates to head towards 5.5% or even higher.

The next question is what does this mean for the equity markets? Should we be reducing our overweight position? Long term interest rates are an important driver of equity valuations and so as they rise equity markets can be subject to downward pressure.

Even with a bearish view of bond yields (say 5.5% compared to 4.85% today), equities could trade on a PE of 18x, which implies upside of at least 10% from here. Naturally if we approach those levels it may become necessary to adjust our weightings to reflect the closing of the undervaluation of equity markets which has been apparent for the past 4 years.

2005 was the third consecutive year that Global equity returns outstripped bond returns by a wide margin. Over the last 3 years the MSCI World index has risen 68% whilst US bonds have given only 6%. There were some excellent performances in regional equity markets, including Japan which rose over 25% and Emerging Markets which returned 34%. The main driver of equity returns throughout the year was very strong profit growth. Many commentators had expected higher US interest rates to slow the pace of earnings growth but in fact most markets saw double digit growth rates. Even in the US which was the worst performing of the major equity markets, S&P earnings are expected to have grown 14%.

We expect economies to continue to grow in 2006, though the headwinds of higher interest rates and higher energy costs should lead to a more moderate pace than in 2005. Company earnings are therefore expected to grow at a reasonable mid-cycle pace of between 5-10%. Given that valuations have fallen and remain at attractive levels, this provides further upside for equity markets over the next year and so we retain an overweight position. We see little value in current bond yields and expect modest returns in 2006.