LONDON, 6 February 2006 — Although markets have had a rough couple of weeks immediately after the start of 2006, we still view the economic environment as relatively favorable for equities. Put simply, we expect continuing economic growth, and hence continuing corporate earnings growth, and view the risks of higher interest rates as relatively modest. Underpinning this point of view is a perception that the inflation threat in the industrialized world is not great even though strong world growth should keep commodity prices relatively high.

That said, we draw some distinction between the US, and the Anglo-Saxon world in general, and mainland European economies and Japan. It is likely that growth in the Anglo-Saxon economies will slow a little over 2006 in response to the monetary tightening of the last couple of years.

On the other hand, we are nearing the end of the Fed tightening cycle and assume no more than two 25 basis point tightening moves in the first few months of this year. This assumption on US interest rates is crucial and if it turns out to be too optimistic we may move to reduce the investment risk in portfolios. Set against this, we expect that economic activity in Europe and Japan will continue to firm in coming quarters and, in response, monetary policy is likely to become tighter.

Despite the absence of a pick up in European inflation, the ECB is expected to hike rates alongside some other European central banks in 2006. We expect at least two 25 basis-point moves from the ECB this year. An end to the Bank of Japan’s policy of aggressive quantitative easing is probably only a few months away.

Clearly a 35 percent commitment to equities in multi-asset accounts represents a substantial investment risk given our absolute return approach. This is one reason why we are keen to reduce risk elsewhere in the portfolios we manage. In recent months we have moved to cut risk in particular in the area of bond exposure.

First the bond commitment has been cut to 35 percent. Second, we have increased the commitment to top-quality AAA-rated government bonds. In allocating 75 percent of our overall bond commitment to government issues, we have reduced the equity-related risk that is inherent in corporate credits. Moreover, our focus is on government issues where there is no risk of spread widening due to poor economic fundamentals. For example, in European portfolios we do not recommend exposure to bonds issued by the governments of Italy, Greece and Portugal. In the higher-risk, non-investment grade area — where we do still expect superior returns — we recommend investment exclusively via pooled investments such as mutual funds.

A second area of focus has to do with currency, in particular the tendency for European multi-asset portfolios to acquire forex risk via security selection. In a global equity portfolio — perhaps 50 percent will comprise US stocks due to US dominance of attractive industries such as health care and IT. Many alternative investments also carry US dollar risk as do many corporate and emerging market bond issues. Thus it is relatively easy to acquire a 35 percent US dollar exposure in European multi-asset accounts. We recommend in principle that this “acquired” forex exposure be hedged back into the base currency of the investor.

We have a similar approach to dollar accounts although “acquired” forex is generally of a lesser magnitude in such accounts and policy is generally of a lesser magnitude in such accounts. This forex policy refers particularly to the major currency crosses such as the USD/EUR. It has less force within the main currency blocs. For example, there is now less volatility among European currencies than was the case a decade ago and hence less reason, for example, to hedge back sterling or euro exposure for Swiss franc investors.

At the present time, however, we do have a strong belief that the yen will strengthen in coming months. We therefore recommend that yen investments up to 5 percent of a total portfolio be retained on an unhedged basis for the time being.

While energy remains a core component of our equity portfolios, we no longer predict near-term out performance and have removed the sector from our favored list. We suspect that “higher-beta” areas such as emerging markets and biotech will lead further market advances in the near-term. Nevertheless, we continue to advocate a broad spread of equity investments across the main industrial sectors.

(Habib F. Faris is vice president at Clariden Bank, London.)