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2006 in general has been a good year for equities with strong growth in global economic output and limited inflationary pressures. The result has been that central banks have kept interest rates at or below their neutral range and bond yields are at historically low levels. While there have been areas which have suffered (most notably Japan and the Middle East) overall the major markets have had their fourth consecutive year of strong growth.

US unemployment is now at its lowest level in five years. Economists are suggesting this is below the level that is consistent with stable inflation. With this in mind the hope is that rate hikes have reached their peak and there is scope for potential cuts during 2007. Inflation will remain a key issue for the US as there is little slack in their market and consequently potential for setbacks. Significant further weakening of the dollar is one of the main risks for financial markets looking ahead. The threat has been there for several years but could become a reality during 2007. The oil price is back down in the region of $60 per barrel, which is positive for economies globally, aiding household and company spending whilst also helping headline inflation. The US housing market is now officially in recession with prices and sales falling dramatically. These figures have filtered through into the overall growth figures for the US.

European markets have been favourable in recent months, with increasing employment and employer sentiment at its highest level for years. The service sectors are performing particularly well and generally growth has been strong. Consequently, there could be scope for further interest rate increases but it is likely they are now nearing the end of their cycle. Inflation again continues to be a key issue for Europe but current predictions indicate a fall to 2.0% in 2007; so rate rises are seen to be nearing an end. In the UK, the Bank of England's Monetary Policy Committee is less nervous about rates; but they will be keeping a cautious eye on growth and housing activity as continued growth in these areas would require further rates increases. For as long as inflation is above target in the UK, the environment remains very sensitive to interest rate increases. Sterling is at a near six-year high, manufacturing is suffering and the global growth outlook is weakening; so any increases could have a serious effect on the overall economy.

It's been a poor year for Japan and investors have not been rewarded for the confidence they put in some of the recent reforms. The market has failed to recover to any degree from the fall in May. The falls can be attributed to a de-rating rather than poor earnings performance. As Japan started to emerge from deflation, it was hoped that there would be a change in the cyclical market trends that have dominated the market for many years; but this has not been the case. Any further improvement in the economy is highly dependent upon a rise in consumer spending. The Chinese authorities are looking to quell the growth in investment spending which is in the region of 25%. If they are successful this will help calm the other Asian markets.

By the end of 2006 the expectation is that global real GDP growth will be slightly over 5% for the 3rd consecutive year making it the best 3 year period since the 1970's. Investors have experienced exceptional returns from a variety of assets ranging from equities in major markets, emerging markets, commodities and indices. Is it now time to pause?

Potentially, the key issue for 2007 is whether the US housing market recession will have a significant impact on consumer spending - and, if so, can other markets de-couple themselves and become insulated from events in the US? Opinion on the effects of the US housing market is divided. Some believe that, with fewer people moving home, there will be few larger purchases made for new homes. Coupled with fewer people releasing equity from their existing properties to fund purchases, this would result in a slump in consumer spending. Others say that equity release has actually been a modest factor in consumer spending, and the slowing will only be modest. Clearly the result will shortly be confirmed but there is the potential for the outcome to be worse than we would like.

Assuming the worst does occur, how will other economies fair? Japan has possibly the largest uphill battle. There are no signs of any stimulus from tax cuts or lower interest rates to boost consumer spending so it becomes reliant upon wage increases. The problem though is that wages and employment are growing very modestly; so the only hope is that lower energy prices will boost spending. This is a double-edged sword, however, as it also presents the danger of tipping the economy back into deflation. The Tankan report (issued mid-December) was generally perceived as optimistic - ultimately contradicting other recent data. This confusion could make decisions difficult for the Bank of Japan in coming months as there is no clear direction for them to take on interest rates. Other Asian and emerging markets also tend to be affected more by weakness in leading indicators which results in underperformance in cyclical markets.

Conversely Europe has the potential to fare reasonably well during a slow down in the US if it is short lived and moderate. Manufacturing has been falling in the US since 2004 but there is still an upward trend in the UK and Europe. While Europe has historically been affected by global trends, domestic issues have started to become more important. The divergence of the US and European housing markets indicates that Europe may well be able to decouple itself from the US and the economy may continue to grow at a reasonable pace during 2007.

The consensus indicates a slow down in 2007 as a result of tighter monetary conditions. The OECD's leading economic indicators have not increased for six months which also confirms a slowing of industrial growth globally. The impact of the US housing recession and the ability for Asia and Europe to decouple from events in the US will be key factors in 2007 and more moderate returns should be anticipated. Currently, equities are still reasonably valued but the danger is that profit predictions for 2007 (approx 10%) are challenging. Going forward there has to be a balance between producing a reasonable profit but not one that triggers inflationary concerns that lead interest rates to rise above neutral levels. This balancing act is much harder to achieve at the end of an economic cycle than at the start of it, when there is spare capacity.

Opportunities for investors could lie in non-correlated assets. Recent years have shown a significant increase in investors holding commodities or commodity funds. This trend is expected to prevail. Even though gold, for example, has been volatile, many commentators continue to believe there is more to be gained from holding precious metals. Some believe the answer to volatility is to shorten the investment time horizon and to exploit the swings to your advantage. Others believe, like we do, that commodities are on a secular bull trend and that buy-and-hold for the long term (instead of trying to anticipate short-term swings) is the right strategy. With such diversity amongst commodity sectors there is plenty of scope for investors to make gains during the coming year.

On balance, we enter 2007 more cautiously than we did 2006 but the outlook is not completely negative. The likelihood of a significant downturn is limited and has already been priced in for some time. Progress can still be made - provided the slowdown is short lived. An easing of US monetary policy could provide a small boost to markets and slower earnings may not be too much of an issue considering current valuations. Identifying opportunities may become more difficult but that does not mean they do not exist for the skilled asset allocator.

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This commentary should not be seen as a recommendation or solicitation to invest. Anyone considering investing should first seek advice specific and appropriate for their own needs, objectives and risk appetite.