The direction of the world’s biggest economy is no less certain following last week’s move by the US Federal Reserve to raise interest rates by a quarter of a point to 3 per cent. This is the eighth time that the Fed has increased rates since June 2004.On the one hand, surging oil, gasoline and raw material costs seem to be taking their toll on the US economy as the Fed works to control rising inflation by continuing its measured pace of rate rises. On the other, global equity markets have weathered the rising costs and interest rates admirably well. In general, companies that have already reported have matched or beaten expectations. However, jitters about economic growth have cast a shadow over markets in recent weeks. For the most part, the world economy has shrugged off last year’s shock rise in oil prices, reflecting the fact that the increase arose from rising economic demand rather than supply-side factors. Oil prices have now retreated from April’s record highs. But now is not the time to sit back and breathe a sigh of relief. Markets are finding little reassurance that Opec’s capacity will be sufficient to meet demand comfortably next winter. Energy prices are now a modest headwind to global growth in the second half of this year. Inflation has moved up the Fed’s agenda. There is still spare economic capacity but the Fed judges that flat monetary policy is too loose to contain inflation. We expect the Fed to raise interest rates further to reach 4 per cent by the end of the year. We now expect profit growth of around 10 per cent year on year for 2005 but we also expect the overall rate of profit growth to slow to around 3 per cent by the fourth quarter compared with the fourth quarter of 2004. Structural imbalances such as the massive current account deficit and the negligible savings rate make the US market an unattractive proposition. We are maintaining our underweight position in US equities, which has proved correct in recent months. In saying that, as bottom-up stockpickers, we still believe that we can add value in actively identifying small, medium-sized and big US companies with strong fundamentals. Generally, investors have been reassured by signs that some slowdown in the two great drivers of global growth – the US and China – has been relatively minor. Nonetheless, the latest spike in oil prices is likely to dampen consumer spending, particularly in the US. The possibility of another soft patch in the coming months is realistic and markets are feeling the uncertainty. As a result, any risk in global equity portfolios becomes less desirable in uncertain markets. Regions where risk can be minimised, such as by reducing exposure in emerging markets, should benefit, particularly on further equity strength in the region and as US interest rates move higher. For the present, we remain modestly overweight in equities, which we believe are likely to continue to outperform other asset classes in the near term. Looking closer to home, we are neutral on European equities and more optimistic on the UK. The UK presents a more favourable opportunity for investors as it is generally a market with defensive characteristics and good stockpicking opportunities. As a rule of thumb, defensive markets tend to remain steady, even when economic growth shows signs of slowing. Valuations in the UK remain reasonable and the market will continue to benefit from mergers and acquisitions. Sectors such as food and beverages have performed well, due partly to Pernod Ricard’s takeover bid for Allied Domecq. We expect relatively good profit growth this year and stable economic expansion although with declines in consumer spending leading to interest rate cuts. As a result, we are currently 2 per cent overweight in UK equities. In continental Europe, the economic picture remains disappointing. The European Central Bank is becoming less confident about economic growth and sees no clear signs of strengthening in underlying dynamics. But the ECB seems disinclined to cut interest rates. Structural changes in Germany are encouraging. German companies have become more competitive and we have seen strong corporate performance, particularly in the export sector. Moving around the globe, good investment opportunities can be found in Japan. Earnings’ growth has been exceptionally strong, which is remarkable in an economy experiencing very modest growth, and it has not yet been reflected in the market. The Japanese profit cycle is likely to slow as wages rise although investors can still find good bottom-up opportunities in companies which are supporting profits through cost-cutting and other operational changes. In the rest of the Pacific region, excluding Japan, the yield premium could lead to outperformance if investors become more defensive and robust domestic growth and attractive equity valuations are supportive. However, rising US interest rates are likely to affect the region negatively. We remain slight overweight in emerging markets to benefit from attractive valuations although we may reduce this position in the months ahead as risk aversion rises. In the longer term, we believe these markets are cheap. With some moderation in economic growth coming, we believe investors should begin to cover their extreme short positions in government bonds, leading to a meaningful rally. We continue to favour Europe, given our belief that eurozone interest rates will stay on hold for the rest of the year while the market is pricing in hikes. Corporate bonds have eased from what we saw as overbought levels. We remain cautious on credit risk as we continue to monitor potential volatility and we believe the correction has further to run. We are focusing on careful stock selection, looking for issuers with potential for credit rating upgrades. We are neutral on high-risk bonds such as high-yield corporates and emerging markets debt. Although fundamental factors are broadly supportive, valuations are increasingly unattrac- tive, given speculative excess in these markets. Against this backdrop, we remain cautious on the outlook for the global economy but still believe there are attractive opportunities to be found around the globe, from Japan to the US, across Europe and in the UK. As statistics from the Invest-ment Management Association showed, investors, advisers, product providers and economists must take a vigilant long-term approach to investing.