The strength of the global economy and the prospects for equities are outweighing concerns about inflation, according to Merrill Lynch’s latest Survey of Fund Managers.

The survey’s growth expectations index rose in May, fuelled by a more positive outlook on economic growth and corporate profits. The net balance of respondents expecting the global economy to strengthen improved from minus 29% in April to minus 18% in May. Investors are less worried about the outlook for corporate profits where the net balance of respondents expecting profits to rise climbed from minus 32% to minus 12%. Furthermore 35% of the panel now expects double-digit earnings growth over the next 12 months, up from 25% in April.

“With every silver lining comes a cloud and with expectations of stronger growth comes the fear that global core inflation is set to rise,” said David Bowers, independent consultant to Merrill Lynch, in a news release. “This has prompted fresh concern among some investors about the outlook for interest rates.”

Investors are clearly bracing themselves for higher core inflation and possibly higher interest rates, Merrill said. The net balance of investors expecting higher inflation one year from now rose from 11% in March to 34% in May. As a result a net 29% expects higher short-term rates versus just 2% in March. And half of respondents forecast higher long-term interest rates, compared with 37% in March.

Despite the threat of higher rates and inflation, asset allocators remain convinced that equities are fairly priced, it reported. A net 52% are overweight equities, up from 50% in April. Allocators believe stocks remain cheap relative to bonds, and corporates have scope to borrow in order to enhance return on equity, with management teams remaining under pressure to return cash to shareholders.

Enthusiasm towards eurozone equities has reached a new level, Merrill said. “Not only do record levels of respondents believe eurozone corporates have the most favourable profits outlook, but investors also believe companies in the region have higher quality earnings than their counterparts in the U.S.,” it said, adding that it’s the first time the market has taken this view since a series of U.S. corporate balance-sheet crises in 2002.

A record net 36% of managers would like to be overweight eurozone equities on a 12-month view and a net 56% are already overweight the region. The last time investors felt so strongly about the region was in January 2000. “The trade into eurozone equities has become crowded, and we understand that contrarians may want to lock in some profits. However, investors should regard any material sell-off as a buying opportunity,” said Karen Olney, head of European Equity Strategy at Merrill Lynch. “Eurozone equities remain cheap relative to the U.S. with strong pockets of value in European large-cap stocks – notably in energy, pharmaceuticals and other sectors such as IT hardware and insurance. And finally the ongoing secular story of healthy domestic growth and an increasing exposure to the East remains firmly rooted.”

Some investors have expressed concern inflationary pressure will force the European Central Bank into several rate hikes. Klaus Baader, chief Europe economist at Merrill Lynch believes the ECB will act without threatening growth, “After years of underestimating the need for the ECB to tighten monetary policy we now see the market is reasonably assessing the prospects for further rate rises with a possible further hike after June,” he said. Merrill Lynch forecasts average eurozone inflation of 1.9% in 2007, rising to 2.2% in 2008.

A total of 201 fund managers participated in the global survey from May 3 to May 10. They manage a total of US$586 billion.