The gloom has started to lift among global investors, amid hopes for improving growth, rising interest rates and weakening prospects for deflation, according to Merrill Lynch and Co. Inc.’s fund manager survey for January. However, the outlook for Europe remains very bleak.

The firm reports that economic sentiment has improved sharply from the lows of late 2008. The proportion of fund managers who predict lower inflation has fallen to 64% from 82% in December. Accordingly, there is a growing conviction that interest rates will increase, with 35% of respondents who forecast long-term rates to increase in the next 12 months, up from 10% in December, it says. Nevertheless, the average cash balance remains high at 5.3%, down slightly from December’s level of 5.5%.

“Investors are talking a more positive story, especially with regards to the U.S., but the fear factor remains,” said Gary Baker, head of Europe, Middle East and Africa equity strategy with Banc of America Securities-Merrill Lynch. “They have firepower to act, but are unconvinced by the modest recent equity rally, suggesting it is a bear market rally in both sentiment and markets. Global sector allocations remain resolutely defensive.”

In Europe, investors remain more pessimistic. Cash positions in Europe have reached their highest level since 2001, with 42% of regional respondents overweight cash compared with 29% in December. Merrill says that the numbers reflect “how, while global economic sentiment is lightening, European expectations remain under a cloud with investors embedded in defensive positions.”

Expectations for a European recession are now unanimous, up from 91% in December. Investors are worried that corporate profits will continue to disappoint, Merrill adds. This distrust means the percentage of investors who believe that European equities are cheap has almost halved, falling to 22% in January from 40% in December.

“European investors are still dancing the two-step and are reluctant to try out any more adventurous moves,” says Karen Olney, lead European equity strategist with Banc of America Securities-Merrill Lynch. “Investors continue to rotate between expensive defensive sectors and beaten but not broken, industrial cyclicals that hope to piggy-back on any indication of infrastructure-related spending by governments reigniting economies.”

Also, Merrill reports that U.S. equities have become less popular with global investors. The net percentage of asset allocators overweight the U.S. equity market fell from 25% in December to just 7% in January. “There has been a notable dip in the U.S. equity market’s popularity and emerging market equities have been the new-year beneficiary of rotation away from the U.S.,” says Michael Hartnett, chief emerging markets equity strategist at Banc of America Securities-Merrill Lynch. The number of investors underweight global emerging markets has fallen to 7% in January, from 17% in December.

Despite the outlook for emerging markets, investors remain cautious about China. “China remains the big global growth wildcard in 2009. Despite the announcement of huge fiscal stimulus packages in recent months, investors remain very skeptical about Chinese and Asian growth,” said Hartnett. “Indeed, Japanese investors notably reduced their expectations for Japan’s growth to close to a record low.”

A total of 205 fund managers, managing a total of US$597 billion in assets, participated in the global survey from Jan. 9 to 15.