At the start of 2004, there were high expectations that the phase of rapid growth in corporate earnings that had begun in the middle of 2003 would continue into the first quarter of this year.

In particular, confidence in the ability of corporate America to bounce back strongly was the key factor in the strong performance of global equity markets during January and February. We now have a full picture of the performance of American and global corporations for quarter one 2004.

These results show that not only have US corporations lived up to these high expectations but they have comfortably surpassed them.

Average earnings for companies in the S&P 500 index have risen by approximately 27 per cent compared with the first quarter of last year, which is much better than the consensus 20 per cent rise forecast by investment analysts.

This comes on top of the 28 per cent increase in the fourth quarter of 2003, which means that these two quarters have produced the best back-to-back growth in corporate earnings since the end of the early 1990s recession.

Most analysts expect that this rapid pace of growth will slow down over the remainder of this year. However, the outlook for ongoing steady profit growth remains good - due to the current strong performance of the US economy.

US share prices responded positively to the good earnings results early in the year but, from March onwards, this rally fizzled out. Equity markets in Europe and the Far East experienced a similar pattern of returns. There seems to be two negative forces that are now outweighing the positive impact of higher earnings. These are higher interest rates and emerging worries regarding higher inflation.

Turning to interest rates first, it is now abundantly clear that US short-term interest rates will begin to rise quite soon, possibly as early as June or July.

The initial rise will be small but it may be the start of a long period of rising rates. If the economy keeps growing, share prices should still be able to advance against such a headwind. However, the markets are now at an inflexion point where uncertainty regarding rates is at its highest, and therefore the fear of the potential negative impact of rising rates is acting to depress share prices.

The second factor that is impacting negatively on investor sentiment relates to some recent data that points to a significant uptick in the rate of inflation. On its own, this modest rise in the rate of inflation should not be sufficient to harm financial markets. If anything, the removal of deflationary fears should, in fact, be positive for markets.

However, it is the context in which the inflation data has turned around that is currently spooking many investors. The recent spike in the price of oil to $40 per barrel has meant that the inflation genie is now out of the bottle. The oil price has now been rising for more than 18 months despite widespread expectations that the price would decline shortly after the ending of the Iraq war.

The deepening crisis in the Middle East means that there will be no quick upturn in the supply of oil from that region. This is occurring at a time when the demand for oil has been unexpectedly strong. The improving American economy - taken in tandem with the booming Chinese economy - has generated a sustained increase in the demand for oil. A slowdown in the pace of the Chinese expansion is widely anticipated, but continued growth in America and Europe means that the demand for oil is likely to only slacken a little.

The surge in the price of oil in recent months has yet to feed through to consumer prices. Up to recently, countries in the euro zone have been almost fully shielded by the strength in the euro exchange rate. However, in recent months the euro has fallen against the dollar just as the price of oil has risen further. It is inevitable that the forecourt price of petrol will rise in coming months.

This turnaround in inflationary expectations is probably sufficient to remove any lingering hopes of a cut in rates from the very cautious European Central Bank. Across the Atlantic, the uptick in inflation may be sufficient to force the hand of the Fed to begin the US tightening cycle early in the summer. This combination of rising interest rates and rising oil prices is a potent mixture that is having a salutary impact on equity markets.

Ironically, once the Fed begins to raise rates, equity markets may stabilise if the move is accompanied by greater clarity regarding the eventual extent of the monetary tightening. Until that occurs, investor sentiment is likely to maintain its current nervous disposition.