Investor sentiment has improved from the lows of 2008, but virtually none of that change is being reflected in actual asset allocations, according to Merrill Lynch’s survey of fund managers for January.

Among the 205 fund managers polled by Merrill Lynch from January 9 to January 15, only around 24% expect the global economy to weaken further over the next 12 months. That’s a sharp drop from 65% in October. In line with the better growth outlook, corporate profit expectations also improved.

Despite the improved sentiment, fund managers are now more overweight in cash, less overweight in bonds, and have generally scaled back regional equity exposure. The fund managers’ average cash balance remains high at 5.3%, albeit marginally lower than December’s 5.5% level. Cash positions reflect risk appetite, with many fund managers normally capping their cash at 5% of their portfolios when they are bullish.

“Investors are talking a more positive story especially with regards to the US, but the fear factor remains,” says Gary Baker, head of Europe, Middle East and Africa equity strategy at Banc of America Securities-Merrill Lynch. “They have the 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 allocation remains resolutely defensive.”

Within a global equities portfolio, the US has slipped out of favour. Only 7% of the fund managers polled earlier this month were overweight in US equities compared with 25% in December.

“There has been a notable dip in the US equity market’s popularity and emerging market equities have been the new beneficiary of rotation away from the US,” says Michael Hartnett, chief emerging markets equity strategist at Banc of America Securities- Merrill Lynch.

US equity exposure has been cut in favour of global emerging markets, particularly China, and Japan. Europe is still seen as the least attractive region, reflecting a more hesitant government policy response to the financial crisis.

“China remains the big global growth wildcard in 2009,” says Hartnett. “Despite the announcement of huge fiscal stimulus packages in recent months, investors remain very sceptical about Chinese and Asian growth.”

China announced a Rmb4 trillion ($585 billion) stimulus package in November, aimed at combating the most serious economic threat to the mainland since the Asian financial crisis in 1997. Before the stimulus package was announced, China was riddled with worries over the impact of the global financial crisis on both domestic consumption and exports.

The stimulus package, with a life span that extends until 2010, covers key areas including  affordable housing, rural infrastructure, railways, power grids, post-earthquake rebuilding in Sichuan, and social welfare to raise incomes. It also includes reforming the value-added-tax system to encourage investment in new technologies.

With foreign reserves and a budget surplus amounting to around $2 trillion, investors are confident that China has the capacity to further stimulate the economy if needed.

Meanwhile, sector-wise, fund managers are most overweight in pharmaceuticals, telecommunications and staples while most underweight in banks, industrials and materials.

The survey was conducted with the help of market research company Taylor Nelson Sofres (TNS).  The survey measures net responses of the 205 fund managers, whose assets under management totalled $597 billion, by taking the balance between the bullish and bearish views for each survey question.