Greater confidence in the strength of global growth and an improving appetite for risk has prompted a more pro-cyclical stance from institutional investors, according to Merrill Lynch’s Survey of Fund Managers for July.

The net balance of those expecting the global economy to strengthen over the next 12 months now stands at minus 5%, sharply up from April’s figure of minus 29%. Corporate profit expectations also rebounded strongly, with only 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, only 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, the lowest level recorded by the survey.

“Despite recent jitters in global credit markets, institutional investors are fully invested in equities with a strong cyclical bias,” said David Bowers, independent consultant to Merrill Lynch, in a release.

Emerging markets are the major beneficiary of a more bullish outlook and the up-tick in risk appetite, with asset allocators aggressively raising their exposure to global emerging market equities at the expense of the U.S. and Eurozone, Merrill says. A net 35% of these respondents say they are overweight emerging market equities, up from 16% just one month ago.

Michael Hartnett, chief Global Emerging Markets Equity Strategist at Merrill Lynch, said 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 midst 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,” says Hartnett.

Pro-cyclical industrial sectors have also benefited from stronger growth expectations and higher appetite for risk, the firm adds. At the global sector level, the big winner is the technology sector. A net 26% of survey respondents say they are overweight technology, sharply 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 greatest threat to financial stability, it finds. This is followed by monetary risk (higher interest rates and/or more volatile exchange rates). The threat to financial stability from protectionism and geopolitics is also seen as high. Asset allocators appear to be least concerned about emerging market risk. Investors also remain relaxed about business cycle risk.

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, the firm notes. 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 US the equivalent numbers are significantly higher at 27% and 37%,” said Karen Olney, head of European Equity Strategy at Merrill Lynch.

A total of 186 fund managers participated in the global survey from July 6 to 12, managing a total of US$618 billion.