Schroder Investment Management is keeping a cautious stance on equities because the impact of the US credit crisis is still being played out.

ôDespite attractive valuations, we would need to see some signs of macro stability before increasing our exposure to the asset class,ö Schroders notes in its June asset allocation report, where it is underweight equities within a global investment portfolio.

In other asset classes, Schroders has turned more positive on bonds, where it is overweight. It has reduced cash from an overweight to neutral. The change in strategy is supported by its quantitative model, which is signalling the end of the global economic slowdown phase and a switch to a recession stage. In the past, this signal brought an asset allocation rotation towards greater risk.

Bond markets have reversed the recent strong rally, with yields now rising as the market discounts further rate hikes on the belief that the worst of the credit squeeze is over while commodity-driven inflation continues to mount. However, Schroders continues to believe there is a strong case for inflation to moderate after a short-lived shock to prices, representing a significant departure from consensus.

Macro fundamentals have continued to deteriorate since the last quarter, with the credit crunch hitting the real economy, Schroders notes.

While the firmÆs forecast for global growth is little changed at 2.9% in 2008, the fund house expects the slowdown to be extended into 2009. It expects both OECD and emerging market demand to weaken, as the credit crunch hurts the OECD and government efforts to combat inflation slows activity in emerging markets. In the US, it expects growth of 1.5% this year, as tax cuts are likely to provide only temporary respite from the effects of the credit crunch and commodity strength, though the country should see a modest recovery moving into next year.

The past quarter has been dominated by a surge in oil prices and inflation expectations. However, Schroders is sticking to its view that the credit crunch will be a considerable headwind on activity so it is not too concerned about inflation. It believes commodity prices should start levelling off and core inflation will stay well behaved as slower growth creates slack and squeezes pricing power. Against this backdrop, it expects global inflation to accelerate to 4.0% in 2008 before edging back to 2.6% next year.

In terms of the risks around SchrodersÆ baseline view, it consider the main threat to its forecasts the possibility that growth overshoots on the downside and inflation remains stubbornly high, leading to a period of stagflation. The other key risk is entering a credit crunch scenario where the economy fails to respond to central banksÆ easing, the fund house adds.

Schroders expects the US Federal Reserve to keep its key federal funds target rate on hold until October when it expects the Fed to cut by 50 basis points to 1.5%, where they are likely to remain until the end of 2009. While inflation concerns remain, the increase in unemployment and the impact of the credit squeeze should ease these price worries, Schroders says, adding interest rates are expected to be cut again once inflation concerns dissipate.

While Schroders expects the European Central Bank (ECB) to reduce interest rates over the longer term, it believes a modest one-off hike as soon as July is almost a certainty. The ongoing slowdown is still likely to force the ECB to cut rates û though this is likely to be delayed until next year û by 50 basis points, the fund house says.

While Schroders believes the time is not right to overweight equities, it notes that if it is right about the macro outlook, the asset class should move into a more favourable phase soon.

ôThe view follows from our analysis of past economic cycles in the US, which suggests that the next phase of the cycle û which we term recession û is one of the best for equity markets and risk assets such as high-yield and convertible bonds,ö Schroders says. ôAlthough this phase is characterised by subtrend growth and falling corporate earnings, equities have consistently delivered returns which are significantly ahead of cash.ö

Within a global equities portfolio, Schroders is overweight in the US and in emerging markets, underweight in the UK and Europe ex-UK, and neutral in Japan and Pacific ex-Japan.