Fund managers are increasingly bullish on both the prospects for economic recovery and a rebound in corporate profits, according to the latest edition of Merrill Lynch’s fund manager survey.

The May survey reports that a majority of investors are now predicting that the world economy will improve in the next 12 months.

“Supported by positive expectations on corporate profits, portfolio managers are backing their optimism with action by putting their money to work,” it says, reporting that average cash holdings have fallen to 4.3% from 4.9% in April.

Respondents remain underweight on equities, but they are more popular than in recent surveys, especially cyclical sectors that are expected to perform best in a recovery. Investors have also moved to a net underweight position in bonds for the first time since last August, it notes.

Additionally, the survey found that many fund managers are rushing to emerging markets, as investor optimism on China’s economy is higher than at any point in the past six years.

“Investors are finally opening their wallets and reducing cash balances to mid-cycle levels to buy equities, cyclical stocks and risky assets,” said Michael Hartnett, Banc of America Securities-Merrill Lynch co-head of international investment strategy. “However, this rush to take on risk, especially in emerging markets, is reminiscent of bubble-like behavior. A record net 40% of fund managers are looking to overweight the region in the next 12 months.”

“Having addressed their most urgent priority by returning to financial stocks, this month, investors have added exposure to cyclical, real economy stocks and further purged defensive overweight positions,” said Gary Baker, Banc of America Securities-Merrill Lynch co-head of international investment strategy.

Sentiment towards the global economy has completed a sharp turnaround, it said, reporting that in the May survey 57% say the economy will improve over the next 12 months, up from 26% in April. Additionally, investors have suddenly become bullish about corporate profits, it notes.

The heightened appetite for equities is concentrated on emerging markets, Merrill says, as 46% of investors are overweight emerging market stocks, up from 26% in April. Bullishness about China’s economy has reached its highest level since the survey began tracking China in 2003, it adds.

The survey also observes an ongoing shift out of defensive investments towards cyclical stocks. “For the first time since early 2005, panelists are underweight (net 2%) their favorite recessionary sector, pharmaceuticals, compared with a net 21% overweight in April. Investors have also reduced holdings in Staples, Telecoms and Utilities in favor of Energy, Materials and Industrials. They have continued to increase allocations to Banks, reducing the net underweight position to the sector’s lowest since June 2007,” it says.

“However, on a less sanguine note, asset allocators have yet to fully embrace equities,” it adds, as a net 6% of asset allocators remain under weight equities globally, with significant underweights in Japan, the eurozone and the UK. “The recharged optimism of fund managers is not fully matched by asset allocators. One upside risk for markets is more asset allocation out of cash and bonds into equities,” said Hartnett.

A total of 220 fund managers, managing a total of US$617 billion, participated in the global survey from May 8 to 14.

IE