The rally in equity markets has now reached a critical level, as the Standard & Poor's (S&P) 500 Index has reached 1,010, and other indices are also testing key levels.

On the one hand, market participants are now actively positioning themselves for acceleration in global activity, driven by inventory re-building as well as growth in China, whilst at the same time, some policy makers, notably the Bank of England last week, remain concerned by the fragility of the underlying economic position still.

This juxtaposition continues to reflect the huge uncertainties of the pace of recovery from the world's worst credit crunch, which now seems to be past the worst, against the huge fiscal and monetary stimuli which have been put to work over 2009, which has had the effect of forcing investors since the market lows seen in March this year, to invest in riskier assets such as credit and equities.

The trigger for current optimism has been much better than expected corporate results, particularly from the U.S. Results have benefited extraordinarily from exceptional cost control inside many companies, over the last year. We are seeing companies announcing operating profit margins which are at a record high, which is odd, given the fact that we're in the middle of a recession. Clearly, however, the outstanding cost-cutting performance that managements are delivering is a finite game. If you cut your costs by 100 per cent, you end up without a business!

But clearly, the market has rewarded managements who have aggressively cut their costs, which has been a key strategy for most companies over the last twelve months as they seek to weather the recession.

Looking ahead, the key issue remains whether we are going to see some re-stocking or economic recovery. Our assessment is that the signals are fairly mixed. In the UK and Continental Europe things are softening or soft, similar to the US, while in Asia Pacific, and particularly in Australia and China, there are some very promising signs.

Chinese growth has been upgraded for the second half of this year and into 2010, while in Australia, the Chairman of the Central Bank has already been talking about raising interest rates as he presently can't see a further downside.

This is an indication that the panic mode is now over and we're looking towards the upturn and the next cycle.

On the other hand, many European industrial companies are really not yet seeing much global re-stocking or increasing activity. Whether this is due to the fact that many industrial conglomerates are basically closing down over the summer and then returning back to normal business in September, or whether it is due to an actual lack of demand, is currently difficult to assess.

This provides evidence for the fact that the worst of the panic in this area is behind us. Unfortunately, there is also clear evidence that many banks' balance sheets remain fairly highly leveraged with dubiously valued products.

Banks have been told to borrow as much money as they need in the shorter term and place it in the markets, which they have done successfully. To put this into context, Goldman Sachs in their peak quarter in 2007 had a return-on equity (RoE) of over 32 per cent. Stripping out the money they received from the government, last quarter they had a RoE of 23 per cent.

The return on banking assets looks as if they are going to be considerably lower than in the past. With RoE at current levels, policy makers are encouraging banks to fund themselves again through the markets as a sense of normality appears, but this is more expensive. Hence, we can expect lower returns over the next six to twelve months.

In Germany, there is talk of balancing the budget. This could be too soon, as we may need another couple of years of fiscal deficits from every country on a global basis to get us through this challenge. The reason why recovery in Japan in the 1990s took over a decade was that every two or three years the government decided to revert to fiscal 'rectitude'. It was at those moments that the economy fell back into recession.

As global governments seek to pay for all the debt they have been issuing, we have to watch for whether they do this too aggressively and whether they focus on certain more profitable areas, such as corporate profits tax or middle and higher income citizens (these people might adjust their spending very quickly, and therefore the government would not able to get out of them what they were hoping to). So, fiscal policy will be a very important thing to watch.

With very low interest rates at present, fears over inflation or deflation are much more muted. Fears over rampant debt-deflation have receded, but concerns over a money-induced inflation bubble in the short term also look overstated. Inflation remains a concern, and most portfolio allocations remain underweight inflation-proof assets.

Many portfolios are still deflation- or depression-orientated. It's important for investors to bear in mind though, that at some point in the future, if we only get moderate levels of inflation the bond market in particular will most likely not be able to hold its present value.

While it may not be easy to find another currency for Asian and other countries to invest in, it has to be borne in mind that one of the solutions for the deficit of the U.S. is for the Dollar to weaken quite substantially.

In terms of corporate profitability, at the moment, profits are down 30 per cent, which is better than expected (our original estimate was for around 39 per cent).

Later in the year, companies will have to give a sighting shot for 2010. We still think that many company managements will be very cautious about their prospects for 2010, and people who are expecting big improvements in earnings may well find themselves disappointed, given the record-high operating profit margins at present.

There is no doubt that market sentiment remains fairly positive and is looking for a much stronger recovery in 2010.

Our concern continues to be that there might be too strong an orientation on a Vshaped (i.e. speedy) global recovery. Anything shallower than that may prove disappointing, in the light of the strong rises in markets around the world which we have witnessed since March this year. However, that disappointment may only come in March next year and may not affect the market for the foreseeable future.