Fund managers are increasingly concerned by the weakness of the global economy and corporate profit growth, though their fears about inflation have diminished somewhat. That is the view of Merrill Lynch & Co., based on its latest global money manager survey, released Tuesday.

The Wall Street firm says its survey of global fund managers for July shows a steady trend toward pessimism about the economy worldwide, with 10% of those surveyed expecting the economic situation to “get a little weaker” or “get a lot weaker” over the next year. In June 9% expected that the economy would “get a lot stronger” or “get a little stronger.” In April, 34% expected positive developments.

“The euphoria we saw at the beginning of the year about the world experiencing a synchronized, cyclical recovery has disappeared,” said David Bowers, Merrill’s chief global investment strategist. “While it doesn’t feel like a recession is around the corner, fund managers are clearly less confident that the recovery can be sustained.”

A net 2% of investors surveyed expect corporate profits worldwide to improve over the next 12 months, down from 11% in June, 26% in May and 47% in April.

Japan is one area in which managers do seem optimistic. Investors’ attitude towards Japanese equities and the yen has been improving steadily, Merrill reports. About 47% of asset allocators are currently overweight the Tokyo stock market, it says. As well, 40% of fund managers said the outlook for Japanese corporate profits is the most favorable worldwide; 24% thought that stock prices there are the most undervalued internationally; 31% said they would most like to overweight Japan over the next 12 months; and, 39% believe the yen to be undervalued.

“The strong view on Japan is somewhat surprising,” said Bowers. “If you believe the world economy is weakening, then Japan is an unusual place to hide given that many of the companies there tend to be driven by cyclical factors.” One additional risk for Japan is the fact that investors are pessimistic about the prospects for the Chinese economy, a substantial contributor to Japanese growth. A net 39% of the panel expect China to get “a little weaker” or “a lot weaker” in the next year, a negative view that’s been in place for three months now.

Meanwhile, U.S. stocks are increasingly out of favor, with 30% of asset allocators underweight, and 43% of the panel picking the U.S. as the region they would most like to underweight over the next 12 months. That is the worst rating for American equities since corporate scandals were raging in early 2002.

With this weaker outlook, fewer fund managers are worried about inflation. Now, 72% expect inflation to be “a lot higher” or “slightly higher” globally over the next 12 months, down from 87% in June. And, “only” 53% consider monetary policy to be “too stimulative,” down from 64% four weeks ago.

Nevertheless, higher interest rates are still widely expected, with 94% of the panel expecting short-term rates to be “a lot higher” or “slightly higher” over the next year, down slightly from 97% in June. 83% of fund managers expect another Fed rate increase within the next three months, while 14% expect the move within the next six months. “Fed policy is still viewed as accommodative,” said Bowers. “Fund managers believe there is a long way to go before monetary policy gets back to a neutral state.” The panel continues to regard a “neutral” Fed Funds rate as being just over 3% on average.

Despite the diminishing inflationary concerns, bond markets are still seen as overvalued, although by a smaller margin, with 49% judging them expensive this month, down from 54% in June. In a possible sign that diminished growth expectations might be leading to concerns about credit quality, a net 15% of managers think government bonds will outperform corporate and/or high yield bonds over the next 12 months.

A total of 275 fund managers participated in the global and regional surveys from July 2 to July 8. Together, they manage a total of US$852 billion.