1998 has been a favourable year so far for global bond investors. A backdrop of Asian instability and plunging commodity prices has taken yields on long-dated government securities down to new record lows across North America, Europe and Japan. The favourable interest rate and inflation setting has also spurred global equity markets, with most major indices posting very healthy year to date returns.

Looking forward, the key to the outlook for global interest rates will be the extent to which the collapse in Asian domestic demand, and instability in the region will slow OECD economic activity. In our view, bond market participants are probably over-estimating the likely size of any slowdown in OECD activity, leaving bond prices vulnerable to a correction as we enter the summer months.

There are already encouraging signs that the Asian situation may be improving, particularly in those economies that have shown the greatest willingness to adopt IMF proposals. Already this year, the Thai and Philippine equity markets have posted 59% and 27% dollar-based returns respectively. In Japan, this year's equity market rally has been led by the banking sector, reflecting the credibility of the administration's financial bail-out package. Recent official government statements give us confidence that the politicians have recognised the need for large- scale fiscal stimulus, including significant tax cuts.

If we turn to the economic backdrop elsewhere, the back-door" monetary easing in the US via declining bond yields has quickly fed through into the interest rate sensitive areas of the economy. Consumer confidence is at record levels, new home sales at 10-year highs and consumer durable purchases are surging. Although production has pausedearly in the year, this has had the benefit of removing the inventory imbalance in the US economy that had built up towards the end of 1997. This leaves the US economy exceptionally well placed to withstand the impact of any deterioration in net exports on GDP growth. With labour market conditions extraordinarily tight, an absence of a significant slow down will inject a note of caution into Federal Reserve policy.

The European economy is also showing promising signs of some recovery in hitherto disappointing domestic demand. Aided by low interest rates, consumer and corporate confidence has improved markedly from a year ago, although unemployment remains very high.

Our asset allocation process is driven both by our base case economic views - broadly outlined above - and by our assessment of the key strategic risks to that view. The scenario dependent approach aims to identify robust strategies which perform well relative to benchmark across a variety of investment environments. Clearly, any investor constructing a global bond portfolio in the current environment cannot afford to ignore the risk of renewed turbulence in Asia. Further instability would probably quickly affect many other non-OECD financial markets leading to a more serious threat to OECD growth prospects and further interest rate declines. Reflecting this, we would not position the portfolio aggressively underweight duration, a stance which our base case would suggest. Rather, we would be much closer to a neutral duration position for Europe and North America combined, with an underweight position in Japanese bonds. We would, however, heavily overweight European versus North American bonds. The steepness of the yield curves in Europe suggests that some of the risks of monetary tightening implied by our base case have been discounted. The US curve, in contrast, is flat, implying no term risk premia has been priced in. Conversely, in the event of a much larger than expected slowdown via further Asian instability, long-dated European securities should benefit by more, as the monetary tightening embedded in the yield curve is priced out. Although US Treasuries may rally, there is currently very little risk premia left to price out. Thus, European bonds appear to offer very good relative value.

David Griffiths is a director of Salomon Smith Barney in London"

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