Fund managers are reassessing their longstanding negative view on bonds, according to Merrill Lynch’s Survey of Fund Managers for August, driven by their pessimism about global growth, concern about the strength of corporate earnings and this month’s pause in U.S. interest rate hikes.

Merrill reports that only 22% of fund managers perceive global bond markets to be overvalued, down from 48% who took this view as recently as May. Moreover, asset allocators have begun to reduce their underweight stance on bonds for the first time in three years — 46% of this panel said they are underweight bonds, versus 65% in June. At the same time, investors continue to exhibit a high level of risk aversion and a net 33% of asset allocators are overweight cash — an all-time high.

“The big call this autumn is shaping up to be: Will this liquidity be directed back into equities or could it head for the bond market instead?” said David Bowers on behalf of Merrill Lynch. “How investors respond to this question may boil down to whether they expect the Fed to be more concerned about the risk of inflation or the risk of slower growth.”

The belief that the global economy will deteriorate over the next 12 months has now become near-consensus, with a net 70% expecting it to weaken, it noted. The vast majority don’t expect this to translate into a recession, but two-thirds of the panel describe the economy as being in a late-cycle phase, Merrill added.

This view manifests itself in concerns about corporate profits. A net 52% of fund managers expect profits to deteriorate over the next 12 months, up from 34% in June, and the percentage who expect earnings per share growth to be 10% or more over the coming year has fallen to 29% from 39% in June. More than half of respondents (53%) expect corporate operating margins to weaken over the next year, up from 40% who expressed this view in June.

Risk aversion remains high for the third month in a row, Merrill observed, with 54% of fund managers looking for equity market volatility to rise from current levels. Also, 43% believe it likely that world stock markets will be lower in six months’ time.

Whether corporate earnings concerns will prompt asset allocators to return to bonds hinges on how Fed Chairman Ben Bernanke perceives the relative risks of higher inflation and weaker economic growth, Merrill explained. 33% say they are more concerned with economic growth than inflation (27%) and the 37% balance reckon the Fed should be equally concerned about both. Merrill Lynch’s view is that economic concerns will increasingly outweigh inflationary worries. Merrill Lynch’s chief North American economist, David Rosenberg, expects the Fed to keep rates on hold until early next year, when he anticipates a rate cut.

Asked whether Fed funds are higher than they would have been had Alan Greenspan still been chairman, most (57%) said no, but 24% agreed with the statement. Participants were also asked whether or not they expected the Fed to adopt an explicit inflation target. Nearly half of respondents (47%) are against such a development, though a sizeable minority (37%) would welcome it.

“This response shows it was a mistake to assume that a new face at the Fed would make no difference,” said Rosenberg. “There’s no question that Bernanke has had more of a challenge communicating than Greenspan. It’s not just the chairman who has departed, but the other resignations that followed. This year, we’ve seen the disappearance of 53 years-worth of policy-making experience,” he said.

A total of 209 fund managers participated in the global survey from August 4 to August 10, managing a total of US$637 billion.

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