Fund managers are starting to face the possibility of global recession, according to Merrill Lynch’s latest survey of institutional investors. The survey shows investors moving out of equities and into cash, in response.

Nearly one in five respondents (19%) now believe that a global recession is either “likely” or “very likely” over the next 12 months, Merrill reports. Also, the percentage of panelists who think that a global recession has already started doubled to 8% from 4% in December.

Merrill says that investors increasingly believe that business cycle risk poses the biggest threat to global financial market stability — now on a par with credit risk and significantly more than counterparty risk. Concern about Europe’s economic health is growing, with a record 80% of respondents to the regional survey who expect the economy to weaken in 2008.

“The period of denial, by some investors, that the credit crunch could have serious repercussions for the real economy may be over,” says David Bowers, independent consultant to Merrill Lynch. “This month’s survey shows an evolution of expectations, from fears of a slowdown to fears of a major recession.”

As investors have become more pessimistic about the outlook for corporate performance, they have been making significant changes to their asset allocations, the firm reports. The vast majority expect profit margins to shrink in 2008; 77% expects profits to grow less than 10% in the next 12 months, compared with 66% who took that view in December and 39% who took that view in October.

The number of asset allocators overweight in equities has tumbled, despite 15% of investors who still view the asset class as undervalued. Only 6% remain overweight equities, compared with 20% in December. Some have shifted towards fixed-income, cutting underweight positions; 28% were underweight bonds in January, compared with 40% who were underweight bonds in December. More notable, however, is an aggressive shift into cash over the past two months; 32% of respondents were overweight cash in January, compared with 26% in December and 20% in November.

Investors are extremely pessimistic about Europe’s corporate earnings outlook; 80% of European fund managers expect earnings per share growth in the region to deteriorate, up sharply from 53% in December, Merrill reports. Fund managers have slashed their holdings in Industrials to underweight and to levels consistent with the May 2006 period of panic, it notes. As a substitute, investors have rushed back into healthcare and oil & gas. They continue to underweight banks, still seen as a value trap.

“While arguments to be bullish on European equities persist, it is clear that investors are bracing themselves for a raft of earnings downgrades. The downside is limited however, as European markets have priced in earnings falling 57% of the way to the trough,” says Karen Olney, chief European equities strategist at Merrill Lynch.

Banks have become the pariahs of the equity markets globally, Merrill says. The percentage of investors underweight Global Banks increased in January to 36% from 27% one month earlier. Merrill Lynch believes that investors will find it easier to make money from buying into bank debt than buying into bank stock this year.

“Banks in 2008 find themselves in a similar situation to telecoms companies in 2002,” said Barnaby Martin, European credit strategist at Merrill Lynch. “Their efforts to deleverage will be bad for shareholders, but good news for bondholders.”

Banks will have to scale back their lending to corporates as a key part of efforts to shore up balance sheets. Companies in cyclical sectors will find their bank lines reduced at a time when it is also difficult to raise capital through bond issues, it says.

A total of 195 fund managers participated in the global survey from January 4 to 10, managing a total of US$671 billion.