Merrill Lynch’s monthly Survey of Fund Managers found investors have taken their most negative stance towards equities in a decade, with 27% underweight the asset class in June.

“Investors’ fears of stagflation have crystallized as they face up to the possibility that interest rates might have to rise as the global economy slows,” it notes. As a result, investors have reduced their exposure to both equities and bonds, moving into cash.

“This month’s survey reflects a world where global growth and profit expectations are deteriorating. At the same time, fears of higher inflation, and subsequent higher interest rates, are rising,” it says. Just 1% of respondents believe equities are undervalued, down from 25% in March. Also, 81% believe consensus earnings estimates for the next 12 months are too high. And, 42% of asset allocators are overweight cash, up from 31% in May.

“The market is waking up to the idea that global interest rates are too low, in fact they remain below inflation,” says Karen Olney, chief European equities strategist at Merrill Lynch. “Negative real rates are hardly an antidote to inflation. Merrill Lynch expects a double rate hike from the European Central Bank by October and would expect other central banks to follow.”

Europe has taken the brunt of investors’ shift away from equities, Merrill said. Over the past 12 months, the Eurozone has moved from most to least favoured, as 29% of investors said that the Eurozone is the region they would most like to underweight on a 12 month view.

Asset allocators have already moved aggressively out of Eurozone equities. It reported that 22% said they are underweight — the most negative stance taken in the past 10 years. Not only has the Eurozone the least favourable corporate profit outlook, but the quality of earnings has been slipping too. This, in turn, is reducing any perceptions that Eurozone equities are undervalued. Also fuelling their negative stance are concerns about the currency, it said, as 71% believe that the euro is overvalued.

Amid these concerns, European fund managers have been moving into cash, Merrill found, as 34% of European investors said they were overweight cash in June’s regional survey, up from 3% in April. Furthermore, a growing number recognises that higher interest rates are likely. In February, half of European respondents believed ECB monetary policy to be too restrictive. That number fell to 10% this month.

The popularity gap between the booming oil industry and the beleaguered banking sector has reached unprecedented levels in the eyes of European investors — 62% of respondents are overweight oil and gas (up from 29% in April). At the other end of the spectrum, 62% are underweight banks (up from 21% in April).

Meanwhile, worries about the credit crunch as the greatest threat to financial market stability are receding. The share of investors citing “credit risk” as the number one threat has fallen from 95% three months ago to 81% in June. But inflation is the fastest growing concern, 65% of respondents cite “monetary risk” as the greatest threat, up from 23% in May.

“For the first time in our memory, inflation, not growth is the primary macro driver at the global level, in our view. The inflation shock has already happened,” says Alex Patelis, head of international economics at Merrill Lynch. “What matters now is how persistent it is and how markets and policymakers react; at a global level this begs for an accident that will awaken markets and policy makers to the risks.”

A total of 204 fund managers participated in the global survey from June 6 to 12, managing a total of US$718 billion.