Investor sentiment reaches new highs

Bullishness in global markets has reached new heights with seven out of 10 investors predicting the world economy will improve in the next 12 months, according to the Merrill Lynch fund managers' survey for May.

Supported by positive expectations on corporate profits, portfolio managers are backing their optimism with action by putting their money to work. Average cash holdings have fallen to 4.3% from 4.9% in April.

"Apocalyptic bearishness of a mere three months ago has been replaced by fairly typical early-cyclical sentiment readings within the May survey," says Michael Hartnett, New York-based Banc of America Securities-Merrill Lynch co-head of international investment strategy.

Equities, while underweight, are more popular, especially cyclical sectors that are expected to perform best in a recovery. Investors have moved to a net underweight position in bonds for the first time since last August. Many 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," Hartnett says. "However, this rush to take on risk, especially in emerging markets, is reminiscent of bubble-like behaviour. A record net 40% of fund managers are looking to overweight the region in the next 12 months."

Gary Baker, Banc of America Securities-Merrill Lynch co-head of international investment strategy, notes that investors have added exposure to cyclical, real economy stocks and further purged defensive overweight positions.

A net 46% of investors are overweight emerging market stocks, up from a net 26% in April. Bullishness about China's economy has reached its highest level since the survey began tracking China in 2003. A net 61% of respondents see its economy improving -- in November a net 87% of the panel expected the Chinese economy to weaken. Now, 80% of GEM investors are overweight in China.

A shift out of defensive investments towards cyclical stocks is ongoing.

For the first time since early 2005, panellists are underweight (net 2%) their favourite recessionary sector, pharmaceuticals, compared with a net 21% overweight in April. Investors have also reduced holdings in staples, telecoms and utilities in favour of energy, materials and industrials. They have continued to increase allocations to the banking sector, reducing the net underweight position to the lowest level since June 2007.

However, asset allocators have yet to fully embrace equities. A net 6% of asset allocators remain underweight 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," says Hartnett.

A total of 220 fund managers, managing a total of $617 billion, participated in the global survey from May 8 to May 14. A total of 182 managers, managing $355 billion, participated in the regional surveys. The survey was conducted by Banc of America Securities-Merrill Lynch Research with the help of market research company TNS, which takes the balance between the bullish and bearish views for each survey question.