Dimmest view of equities in a decade
Europe bears brunt as allocations reach new extremes

Fears of inflation shocks have overtaken waning concerns over the global credit crunch as the as the greatest single threat to financial market stability and profit expectations among global equities fund managers.

According to the latest Merrill Lynch survey of 185 fund managers with US$718 billion in assets on their books, only one percent of the respondents believe that equities are undervalued – down from 25% in March.

The survey noted that with fears of stagflation heightening, many have reacted by reducing exposure to both equities and bonds and moving into cash on concerns that interest rates will have to rise to tame inflation even as the global economy slows down.

A net 42% are overweight in cash, up from 31% percent in May. Eight out of 10 respondents are also of the view that consensus earnings estimates for the next 12 months are too high.

The result is that asset allocators have now taken their most negative stance towards equities in a decade, with a net 27% underweighting the asset class in June, Merrill Lynch noted.

"The market is waking up to the idea that global interest rates are too low. In fact they remain below inflation," said Karen Olney, chief European equities strategist at Merrill Lynch.

She added, "Merrill Lynch expects a double rate hike from the European Central Bank (ECB) by October and would expect other central banks to follow."

The net percentage of investors citing "credit risk" as the number one threat has fallen from 95% three months ago to 81% in June. Inflation is the fastest growing concern with a net 65% polled citing "monetary risk" as the greatest threat, up from a net 23% in May.

"For the first time in our memory, inflation, not growth is the primary macro driver at the global level. The inflation shock has already happened," said Alex Patelis, head of international economics at Merrill Lynch.


Europe to bear the brunt

Merrill Lynch said the shift away from equities among fund managers is most pronounced in the Eurozone, which has moved from being most to least favoured within a year.

For a net 29% of investors – it is the region they would most like to underweight on a 12-month view. Many have already moved aggressively out of Eurozone equities.

A record 22% said they are underweight – the most negative stance taken in the past 10 years – due to views that the quality of earnings has been slipping.

Many European fund managers have been moving into cash. About a third they were overweight cash in June's regional survey, up from 3% in April.

Also fuelling the negative stance are concerns about the currency – with a net 71% of asset allocators believing that the euro is overvalued, a particular concern for a region heavily dependent on exports.

Merrill Lynch said a growing number recognises that higher interest rates are likely. In February, half of European respondents believed ECB monetary policy to be too restrictive. That number fell to a net 10% this month.

Any bearish tendencies towards the Eurozone are, however, dwarfed by the negative stance global investors are taking towards the United Kingdom, with 38% underweight, tempered by fears over sterling.

Even after an 11 percent fall in sterling's trade weighted index over the past 12 months, 56% still believe the currency to be overvalued.

The popularity gap between the booming oil industry and the beleaguered banking sector has also reached unprecedented levels in the eyes of European investors.

A net 62% of respondents are overweight in oil and gas stocks, up from 29% in April. At the other end of the spectrum, 62% are underweight in banks compared to 21% in April.

"Fundamentals absolutely support oils over banks. The sector has the strongest earnings momentum in Europe and is also among the cheapest. The burning question is when to sell oil companies and move back to banks," said Olney.

Merrill Lynch forecasts an average price of U.S.$121.50 per barrel in the second half of 2008 and an average price in 2009 of U.S.$107 per barrel.


by A J Leow

Also check out the following detailed Merrill Lynch reports on:
      • Global Fund Manager Survey (June 2008)
      • Global emerging markets (GEM) strategy
      • Global economics: More on Inflation

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