THE year just ended has been one of by the all powerful US bond, the best ever far financial markets, and equity markets. In pound terms, the Irish and US equity markets have produced returns in the range of 20 per cent to 30 per cent. Due to the [strength of the pound against sterling, the British stock market produced more modest returns of around 15 per cent.

A major factor driving up equity markets was the strength of bond markets a sharp contrast to the severe bear markets of 1994. Yields at the long end of the Irish bond market have declined from 9 per cent to 7.5 per cent, producing total returns of more than 18 per cent for the year.

What lies behind the extraordinary strength of financial markets during 1995? I would identify three key reasons for last year's bull markets:

. Deflation: A key factor driving markets over the past 12 months has been the intensification of deflationary forces. Improvements in technology are driving productivity growth which is combining with cut throat competition in most markets to tame inflation. In addition, the tightening of US monetary policy, begun in early 1994, has all but eliminated any pressure on inflation from the economic cycle.

. Cyclical factors: In early 1994, the US Central Bank started to increase interest rates thus tightening monetary policy throughout 1994. The lagged effect of this tighter monetary policy engineered by the Federal Reserve slowed economic growth unexpectedly quickly in 1995. This brought forward the timing of renewed monetary easing and we have seen cuts in interest rates in Europe, Japan and the US from the second quarter of 1995.

. Productivity miracle: Corporate restructuring and the widespread application of information technology is paying dividends in terms of improved efficiency and enhanced corporate profitability.

Therefore, the slowdown in the pace of economic growth has not seriously dented the prospects for continued rises in corporate profits.

The Irish economy and financial markets are participating with gusto in this golden scenario. The economy is responding very well to low interest rates and an exchange rate that remains competitive despite appreciation against sterling. At 67.4, the effective index is only marginally above the level of 66.2 in 1994 and is still 3 per cent below the 1992 level.

. The year ahead: This year the omens for the global economy remain bullish. Inflationary pressures will remain subdued over the next three to six months. Slower economic growth increases the chances of continuing cuts in short term interest rates, while liquidity conditions are becoming easier in all the major currency blocs, reflected in strong growth in bank lending in many economies.

The Irish economy is well positioned to benefit from this benign global environment and economic prospects for the next two years are exceptionally bright. The economy should continue to enjoy rapid economic growth. The debt/GNP ratio will continue to decline and lower European interest rates should be fully reflected in the Irish market:

The risks to this optimistic scenario are threefold. The current global economic slowdown could turn into an outright recession which would adversely impact on Irish growth, thus creating a very difficult environment for reducing the debt burden.

While somewhat slower growth than current consensus expectations is likely, such an outcome would not seriously dent Irish growth. The chances of an outright recession occurring in an environment of low and declining interest rates are low.

The current downwards trend in interest rates could be reversed by currency turmoil - or a too rapid rise in monetary aggregates. There is no doubt that the Irish economy is - responding well to lower interest rates and a sustained rise would have a substantial negative impact. With inflation so subdued, we rate the chances of a sustained upturn in interest rates as very low.

European Monetary Union and the prospects for EU transfers represent serious medium term risks but should not have an impact on the financial markets over the next 12 months or so.

Looking into the crystal ball, investors will be rewarded with reasonable returns in 1996. However, the risks of profit disappointments are high given that economic growth is slowing and therefore bonds look somewhat more attractive than equities. For the Irish market I would expect the ISEQ overall index to be only marginally higher at 2300 by the end of 1996, while bond yields at the long end could well have declined to 7 per cent from the current levels of 7.5 per cent.

If this assessment is correct it would result in returns of 10 per cent or so from the long end of the bond market and returns of 5 per cent to 10 per cent from the Irish equity market in 1996.