Inflation fears muted: Merrill study

Global fund managers have expressed a more optimistic outlook on the global marketplace, with improving corporate earnings trumping the threat of inflation, according to Merrill Lynch’s latest Survey of Fund Managers report.

While the outlook remains tepid, the balance of managers predicting improved economic growth shifted slightly in May. The survey found a net balance of -18% predicted continued growth, an improvement from the -29% in April. The Merrill survey reports its findings in terms of net balance, meaning a 50-50 split would result in a net balance of zero.

The outlook for corporate profits also improved, with a net balance of -12% expecting higher earnings, compared to -32% last month. Thirty-five per cent of respondents predict double-digit earnings growth over the coming year, up from 25% in April.

The threat of inflation has not been completely written off, however. A net balance of 34% of respondents expect that higher inflation rates are in the offing, compared to a net balance of just 11% in March. That should drive interest higher as well, the fund managers say, with a net 29% expecting short-term rates to rise.

The expectation of rising interest rates makes bonds less attractive, while rising corporate profits further tilts asset allocations toward equities, the study found. A net 52% are overweight in equities, up from 50% in April.

“Allocators believe stocks remain cheap relative to bonds, and corporate [bonds] have scope to borrow in order to enhance return on equity, with management teams remaining under pressure to return cash to shareholders,” the report points out.

Fund managers are particularly impressed with the quality of earnings in the EU, rating them higher than earnings in the U.S. for the first time since 2002, when American balance sheets were a mess. A net 36% of managers “would like to be” overweight in European stocks, according to the survey, and a net 56% already are.

“The trade into eurozone equities has become crowded, and we understand that contrarians may want to lock in some profits. However, investors should regard any material sell-off as a buying opportunity,” said Karen Olney, head of European equity strategy at Merrill Lynch.

“Eurozone equities remain cheap relative to the U.S. with strong pockets of value in European large-cap stocks — notably in energy, pharmaceuticals and other sectors such as IT hardware and insurance,” she said. “Finally, the ongoing secular story of healthy domestic growth and an increasing exposure to the East remains firmly rooted.”

There is some fear that the European Central Bank will raise interest rates to choke off inflation, which could inadvertently stifle growth, but Merrill’s chief Europe economist, Klaus Baader, expects the ECB will not make any drastic moves, and that inflation will rise to just 2.2% in 2008.

Methodology note: A total of 201 fund managers participated in the global survey from May 3 to May 10, managing a total of U.S. $586 billion US. A total of 177 managers participated in the regional surveys, managing $397 billion US.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com