Merrill Lynch’s Survey of Fund Managers for October finds that, while stock markets are reaching new highs, market fundamentals are weaker than before the recent turmoil in world markets.

The survey reports that the macro-economic outlook has improved in the past month but is less bright than three months ago. The net balance of respondents expecting global growth to deteriorate increased to 55% in October from 5% in July. The balance expecting a worsening of corporate profits (44%) improved from September – but is much higher than in July (12%).

“Investors are preparing for a new environment in which earnings growth will become increasingly scarce,” said David Bowers, independent consultant to Merrill Lynch, in a release. “When it comes to investment style respondents are expressing a marked preference for growth over value. The trouble is that investors can identify only three sectors with strong growth characteristics; technology, materials and industrials.”

The U.S. Federal Reserve’s interest rate cut played an important role in fuelling the recent equity rally. However risk appetite has yet to recover to levels seen in July, the firm notes. Portfolio cash levels were down to 4% in October from 4.3% in September, but significantly higher than the 3.4% recorded in July. Investment time horizons are shorter, portfolio risk is lower and liquidity conditions remain weaker than in July, Merrill says.

At the same time, the 50 basis point cut has also reignited inflation fears. Inflation concerns resurfaced in October but remain below levels three months ago, Merrill reports. The net balance of respondents expecting core inflation to rise over the next 12 months leapt to 33% in October from 4% in September, it said. These concerns have prompted a bearish outlook for long term interest rates – the net balance expecting higher bond yields rose from to 43% from 26% in September.

Despite these fears, asset allocators remain overweight equities, the survey finds.

Emerging markets have been the biggest regional beneficiary of the rate cuts and market rally, Merrill notes. The region is home to many companies in technology, materials and industrials.

The Fed’s interest rate cut is also helping to boost commodity prices and set the stage for further strength

Commodities, as an asset class, tend to work as a hedge against inflation, Merrill notes. Metals, which largely escaped the credit crunch unscathed, are performing well with precious metals profiting from growing risk aversion and a weaker U.S. dollar. Merrill Lynch also recently revised its fourth quarter crude oil price forecast to US$80 per barrel from US$67.50 on the back of slower-than expected supply growth.

A total of 209 fund managers participated in the global survey from October 5 to 11, managing a total of US$671 billion.

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