Pessimism about prospects for economic growth and corporate profits has deepened among global investors, according to Merrill Lynch’s Survey of Fund Managers for December.

However, investors are clinging to the idea that the rest of the world can decouple itself from the housing crisis in the United States.

Fund managers are sticking to an investment strategy that regards stocks as cheap relative to bonds, Merrill notes. They believe the rest of the world economy can decouple itself from the U.S. mortgage crisis, and they continue to favour “growth” assets such as emerging markets over “value” assets such as financial services.

For much of the year the strategy has worked well, Merrill notes. However, since June, stock returns have lagged bond returns and, over the past six weeks some of the global sectors exposed to emerging-market economies, such as industrials and basic materials, have underperformed.

It reports that 60% of fund managers now expect corporate profits to deteriorate in the next 12 months — the most pessimistic response in almost a decade — and 62% expect the global economy to weaken. “Pessimism about the global economic outlook suggests that 2008 could be the year that the decoupling thesis faces its sternest test,” says David Bowers, independent consultant to Merrill.

Fund managers believe that earnings growth is set to become a scarcer commodity, with 80% of them believing that firms are unlikely to see double-digit profits growth over the coming 12 months. Cost cutting is expected to be the primary source of earnings growth as the business cycle becomes increasingly mature; 74% of the panel now believe the world economy has entered the late-cycle phase versus 62% in September. However, while expectations for economic growth and corporate profits in December are among the most pessimistic the survey has recorded, only 13% of respondents expect an outright global recession in 2008.

Investors preference for emerging markets continues despite a sharp rise in the number of fund managers expecting a slowdown in China’s economic growth. A net 25 % of respondents expect the Chinese economy to weaken in 2008. Only 4% in took this view in November.

Also, 19% of respondents are overweight eurozone equities, sharply down from 50% six months ago, with the UK hardest hit. The balance of asset allocators underweight UK equities rose to 26% in December – one of the most bearish stances taken on the UK market – amid growing concern that sterling is overvalued.

“Germany’s status as the world’s largest exporter leaves investors feeling exposed. To avoid getting caught in the crossfire between a spiraling euro and slowing global growth investors go domestic,” says Karen Olney, chief European equities strategist at Merrill Lynch. “Over twice as many investors prefer domestic, versus overseas, growth. They have battened down the hatches and moved into defensive, domestic growth, such as telecoms and personal & household goods and utilities.”

Despite all these concerns, asset allocators still prefer equities over bonds, 13% think equities are undervalued while 43% believe bonds are overvalued.

“Continental European bonds could remain constrained though a lack of action from the ECB,” said Andrew Roberts, chief European fixed-income strategist at Merrill Lynch. “However elsewhere we think government bonds are a great investment in 2008, as the US and UK lead the way to lower yields and strong returns, driven by weakening economies, rate cuts and a liquidity crisis that is here to stay.”

Investors remain surprisingly relaxed about inflation. A net 15% expects global core inflation to rise next year, down from 35% in November.

A total of 195 fund managers participated in the global survey from December 7 to13, managing a total of US$689 billion.