Investors are waiting for the right conditions to return to equity markets amid the most pessimistic outlook yet recorded, according to Merrill Lynch's Survey of Fund Managers for October.

The survey, completed as global equity markets fell in value by 18.7 percent, shows that almost seven out of 10 respondents (69 percent) believe that the global economy has entered recession, up sharply from 44 percent one month ago. The proportion of investors who believe that monetary policy is too restrictive has reached a net 59 percent, representing a new high for the survey.

But low risk appetite and a belief that equities are undervalued could provide the foundations for a rally. Growing risk aversion has led to a record 49 percent of respondents who are overweight cash. The number of respondents who believe equities are undervalued has reached a 10-year high, at 43 percent.

"Fund managers are waiting for the triggers that will give them the confidence to buy," said Gary Baker, head of EMEA equity strategy at Merrill Lynch. "What they are looking for is a loosening of monetary conditions and for third quarter earnings to clarify where problems and opportunities lie across equity markets."

Impact of the financial crisis

Third quarter earnings season will be a vital input to investors' portfolio decision making and to gauging how the financial crisis has impacted the real economy. Respondents appear to be placing little or no credibility in consensus earnings estimates for the year ahead. A net 92 percent of respondents regard estimates as "too high," and more than half say estimates are "far too high".

At a time of global pessimism, the gloom is no more concentrated anywhere in the world than in Europe. A net 41 percent of global asset allocators are underweight euro zone equities. Europe has now assumed the UK's mantel as the world's least popular destination for equity investment.

The view of respondents within the euro zone is just as bleak. A record nine out of 10 respondents expect economic conditions to worsen, while the net percentage of European specialists forecasting recession has doubled to 74 percent from 37 percent in September. The outlook for corporate earnings can hardly worsen, given that 97 percent believe EPS growth will be weaker in the 12 months ahead.

"Against this backdrop of fear over profits and recession, investors are selling expensive, highly cyclical industrials and opting instead for stable dividends and capital preservation," said Karen Olney, lead European equities strategist at Merrill Lynch. Investors have stampeded out of Industrial Goods & Services over the past month, with 49 percent underweight the sector compared with eight percent in September.

The biggest overweight positions are in Telecoms and Healthcare, which traditionally provide safety and income. European sector allocation shifts over the past month suggest that investors have been moving towards remain pockets of potential growth that are less exposed to the credit crisis, such as Media and Technology. Fewer European investors are underweight Media, underweight positions fell sharply in October from a net 33 percent in September. A net 39 per cent are now overweight Telecoms, an increase of two percent.

Deep and prolonged US recession

The survey also found US fund managers are now much closer to fully accepting what they expect will be a deep and prolonged US recession. "In our view, however, it is too soon to say we have reached a bottom in equity markets given the current financial market turmoil," said Sheryl King, senior US economist at Merrill Lynch.

Landmark financial rescue measures announced by governments in Europe and the UK to address bank security and liquidity will be positive, but will fundamentally alter the way bond investors approach banks. Banks are now in a position to refinance €250-billion of maturing debt, a relief for credit investors. However investors will need to be aware that the plans are set to create a new super senior tier of bank debt. Any new state-backed debt will outrank existing debt in the bank's capital structure.

"The subordination of existing debt is a small price to pay for this rescue," said Richard Thomas, head of EMEA bank credit research. "More importantly, investors will see banks as an adjunct of the public sector – not just in terms of state ownership and debt guarantees but also as their lending activities take on an element of public policy."

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