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Greater confidence in the strength of global growth and an improving appetite for risk has prompted a more pro-cyclical stance on the part of institutional investors, according to Merrill Lynch ’s Survey of Fund Managers for July.
The FMS Composite Index of Growth Expectations rose again this month to 46, its high level in more than a year. The net balance of those expecting the global economy to strengthen over the next 12 months now stands at minus 5%, up from April’s figure of minus 29%. Corporate profit expectations also rebounded, with a net 12% expecting the outlook for corporate profits to deteriorate over the next year, versus 38% who took this view in April.
At the same time, the FMS Composite Indicator of Risk Appetite and Liquidity rose to 42 from 40, bringing it in line with its five-year average. A net 12% of the panel report below normal risk appetite, down from 18% in June. Significantly, cash balances fell to 3.4% from 3.7% last month, low level recorded by the survey.
According to Merrill Lynch, despite recent jitters in global credit markets, institutional investors are fully invested in equities with a strong cyclical bias.
Boost for Emerging Markets
Emerging markets are the major beneficiary of a more bullish outlook and the up-tick in risk appetite, with asset allocators raising their exposure to global emerging market equities at the expense of the U.S. and Eurozone. A net 35% of these respondents say they are overweight emerging market equities, up from 16% just one month ago.
The survey shows the extent to which emerging markets have been able to shrug off credit worries seen in the U.S. sub-prime mortgage market. Emerging markets continue to be in the mid of a substantial secular bull move. However, the strength of the recent rally – which has seen GEM equities up 35% from their March 2007 lows - may result in some profit-taking.
Pro-cyclical industrial sectors have also benefited from better growth expectations and higher appetite for risk. At the global sector level, the big winner is the technology sector. A net 26% of survey respondents say they are overweight technology, up from 16% in June.
Consistent with this more pro-cyclical stance, investors have reduced their exposure to consumer staples and pharmaceuticals and are also favouring other economic sensitive sectors such as energy, industrials and materials.
Credit risk poses great threat to financial stability
In a new question this month, Merrill Lynch asked asset allocators to rate seven potential risks to financial market stability. Respondents were asked to score each risk in terms of the threat they thought it posed to financial market stability. The risk that is more elevated at present is credit (default) risk, regarded by a net 72% of the panel as above normal.
This is followed by monetary risk (higher interest rates and/or more volatile exchange rates) at a net 44%. The threat to financial stability from protectionism and geopolitics is also seen as high and both score a net 39%. Asset allocators appear to be less concerned about emerging market risk, with a net 18% viewing this threat as below normal.
Investors also remain relaxed about business cycle risk, with a net 8% of asset allocators regarding the threat of financial instability from a more volatile business cycle as above normal.
European equity markets could withstand a credit event
With credit risk being the big threat to financial stability, Merrill Lynch looks at the impact on the European market. If financial markets do face a major credit event, then private equity deals, which support market valuations, will become more expensive as the risk premium on credit rises.
However, the impact on stock market valuations is likely to be less worrying for Europe than the U.S. In Europe the proportion of LBOs in relation to total M&A activity for 2006 and 2007 is 18% and 13%, while in the U.S. the equivalent numbers are `higher at 27% and 37%.
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