Concerned about US rate rises, the slowdown in China, rising oil prices and problems in Iraq? All these factors are likely to make life more difficult for equities, but it's too early for investors to become negative just yet.

So far this year, equity markets have struggled to build on the good gains of 2003, despite robust growth and strong corporate earnings. The Federal Reserve has put markets on notice that higher US interest rates are on the way, and confirmation that China is serious about slowing down its economy hasn't helped equities either. The same might be said of worries over oil prices, terrorism and Iraq.

US interest rates over the next 12 months are unlikely to rise to the sort of levels that would cause serious problems for stocks, however. A "neutral" level - a rate that neither slows down nor speeds up the economy - is probably around 4%.

We expect the Fed to raise rates at their mid-August meeting, beginning a period of prolonged but gradual tightening. That's partly because of the US presidential election in November, but mainly because of the slack still in the economy, the low starting point for inflation, and the prospect that productivity growth will stay strong.

In fact, these are the big differences between 2004 and 1994, which was the last time the Fed was forced to move aggressively. We anticipate 25-basis-point steps, with rates reaching between 2.0% and 2.5% by the second quarter of 2005. That might be a long way from the 1% level where we are now, but it's well below neutral levels, making it neither too much of a drag on the economy, nor too much of a threat to US equities.

Those higher rates and less of a fiscal stimulus will probably slow down growth in the United States' gross domestic product (GDP), but a sharp slowdown is unlikely because investment should stay strong and the better jobs market will probably keep consumers spending. While we anticipate real GDP growth will slow to between 3% and 3.5% a year over the next 12 months (down from between 4% and 4.5% a year in the first three months of 2004) that's in line with the United States' long-run sustainable growth rate, and it should be good enough for equities to move forward.

Elsewhere, the weak dollar should keep interest rates relatively low. Growth in the 'eurozone' is likely to remain very sluggish, but its upswing probably won't stall completely. Rates are also likely to stay low in Asia, where, in contrast to the eurozone, domestic consumption spending is picking up. Economic growth in Japan and the rest of Asia will probably slow down because of weaker export demand from the US and China, but not too much provided China avoids a crash landing.

Gently does it
The markets are worried that the Chinese authorities will overdo the tightening and bring the country's real GDP growth rate down so sharply that it badly hits the global upswing. A gradual slowdown is always difficult to engineer, especially in China where large parts of the economy remain beyond market forces, but it is probably too early to worry about a hard landing.

China does need to slow its economy down, but it isn't out of control, and neither is it facing a major inflation or overheating problem. The issue is one of over-investment in a few sectors, so the solution is a gradual, piecemeal, highly focused tightening - just what the authorities are doing.

Draconian tightening measures, such as sharply higher interest rates, are not needed and the authorities will continue with their current approach for a while. Consumption is now a much more important part of China's economy than it was in the early 1990s, the last time China tried (and failed) to slow things down gradually. Household incomes have grown, housing has been privatised and consumer credit is more widely available, so weaker investment should be offset by stronger spending by consumers. GDP growth shouldn't slow too much.

Still in the black
Corporate profits in most markets should also remain a good story and helpful to equities. In the US, profits have come back sharply. In the first quarter of 2004, S&P 500 profits beat expectations and rose around 25% year-on-year.

But this great result is probably as good as it gets for a while. Year-on-year comparisons will become tougher from now on, so US profits growth will likely slow to around 15% per annum by the end of 2004, and down to between 5% and 10% per annum by late 2005. This is still a pretty good outlook that should support US equities, but profits growth outside the US probably won't slow as much and this is another reason to favour non-US equities. In Europe, gradual economic recovery should support profits, while in Asia corporate restructuring and better balance sheets should mean that profits growth stays in the range of 10% to 20% a year.

As for valuations, the market's price-earnings (PE) ratio in the US is now close to its average level over the past 20 years at around 20 times earnings. But the 20-year average is biased on the high side because of the late-1990s bubble years, and the century-long PE ratio in the US is 15 times.

As long as economic news remains good, current relatively high valuations are probably justified, but the US market is vulnerable to bad news. US equities should still deliver moderate positive returns over the next 12 months - say 5% to 10% a year - rather than fall back sharply, but moderate returns will probably come with increased volatility.In Europe, valuations are also demanding given sluggish economic growth, though eurozone interest rates are likely to stay on hold at 2% well into 2005, and could move lower. UK large-cap indexes are heavily dominated by defensive sectors and should hold up reasonably well, but the markets that are likely to perform best of all are Japan and Asia ex-Japan. Valuations in Asia remain attractive, the profits outlook remains good, and interest rates are likely to stay low