Debt Crisis Seen as Damaging Prospects for Eurozone

Investors’ confidence in the outlook for global growth and corporate profits has dipped, according to the Bank of America Merrill Lynch (BofA Merrill) survey of fund managers in May 2011. The proportion of the panel believing that the world economy will strengthen in the next 12 months has fallen to a net 10%, down from a net 27% in April and a net 58% as recently as February. Similarly, only a net 9% of respondents now look for corporate profits to improve in the coming year.

Participants’ lower conviction is most evident in Europe, where expectations turned negative in May, with a net 8% expecting the region’s economy to weaken in the next year. Just two months ago, a net 32% forecast that it would strengthen. This reflects investors’ identification of the eurozone sovereign debt crisis as the largest tail risk globally (up to 36%, from 21% in April).

With prospects for growth more challenging and inflation fears receding, asset allocators have postponed their expectations of a rise in US interest rates. In the April survey, 69% of participants anticipated the Federal Reserve first hiking rates by the end of this year; now 73% sees this occurring in 2012.

Against this accommodating background, risk appetite has fallen only modestly. Fund managers trimmed exposure to equities and commodities, while adding to cash and bond holdings slightly. Risk aversion is more evident in strong sector rotation into more defensive areas, such as consumer staples and pharmaceuticals, and out of more volatile and growth-dependent sectors, such as energy and materials.

“A triple dip in growth expectations is reshaping investors’ stance on risk,” said Michael Hartnett, chief global equity strategist at BofA Merrill Lynch Global Research.

“A risk for investors is that pessimism on Europe now looks to be overdone, particularly in light of strong recent GDP data,” added Gary Baker, head of European Equities strategy at BofA Merrill Lynch Global Research.

Emerging Markets Equities Favoured Despite Lower BRIC Conviction

A net 28% of regional fund managers expect China’s economy to weaken in the coming year, up from a net 15% in March. Despite this and lower confidence in other important Brazil, Russia, India and China (BRIC) economies, allocations to emerging market (EM) equities continue to rise.

A net 29% of the panel now has an overweight position in EM equities. This represents the highest reading in any region this month and compares with a net 0% two months earlier.

This positive stance partly reflects the earnings outlook in emerging markets. A net 19% of respondents believe that EM corporates are most favourably positioned to grow profits (second only to the US). It also reflects growing optimism on domestic demand in emerging markets. A net 42% sees this as the most important driver for EM equities, up from a net 5% in March.

Belief in Japanese Growth Rebounds

Two months after the earthquake and tsunami in the northeast of Japan, investors have scaled back their initially negative views of the events’ impact. In April’s survey, respondents were divided evenly between those expecting the country’s economy to weaken in the next year and those expecting it to strengthen; this month, a net 59% sees it strengthening over the period.

Moreover, a net 38% expects Japanese companies to improve earnings per share in the next 12 months. This compares with a net 33% in April seeing earnings per share (EPS) declines. Sentiment towards Japanese equities began to repair, with April’s net underweight (18%) improving by a percentage point in May.

The panel continues to avoid exposure to the yen, however. A net 64% regards the currency as overvalued – little changed from the previous three monthly readings.

Currency Contrasts: Euro Overvalued, Dollar Undervalued

In contrast to their views on the yen, respondents have intensified strong views on the world’s other key currencies. Underscoring lower confidence in the eurozone’s prospects, a net 60% now views the euro as overvalued, versus a net 40% one month earlier and a net 25% in February. This represents the highest reading since December 2009.

A net 48% views the US dollar as undervalued, up from a net 36% in April. This accords with participants’ constructive stance on the US outlook. Besides the profit picture for US companies, this is also visible in respondents’ selection of the US as the regional equity market they most favour for overweight positions in the next year.


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