Investor sentiment has ôstepped back from the brink of despairö, but more than a third of investors are nevertheless waiting to see greater fiscal stimulus, according to the latest Merrill Lynch fund managersÆ survey.

Many fund managers û 88% of the respondents surveyed in early December û believe that the world economy is in recession. However, far less of them believe that the world economy is deteriorating further. The net balance of investors who expect the global economy to worsen in the coming year has dropped to 36%, down from 60% previously.

A glimmer of hope is taken from the fact that more than a quarter of the respondents believes the world economy will strengthen in 2009.

Despite the less gloomy expectations on the economy, cash levels of fund managers are at 5.5% up from 5.1% in November, the highest level since 2001. This suggests that these excess cash holdings could be freed up in the coming weeks as fund managers hunt for bargains.

ôMarket sentiment, high cash levels and the prospect of US fiscal stimulus in January point to a possible New Year rally in equities,ö says Gary Baker, head of Europe, Middle East and Africa (EMEA) equity strategy at Merrill Lynch. ôIt suggests that going into 2009 with textbook defensive positions in a small number of sectors could be dangerous.ö

For the third straight month, the majority of fund managers believe equities are undervalued. For now, they still view equities with scepticism, however.

Many fund managers still prefer bonds to stocks, with a net 21% of the respondents overweight in bonds in December, compared with 7% in November.

Problems could be in store for those who stay heavily invested in fixed income though, according to Merrill Lynch. Following the recent sharp rally in government bonds, a net 42% believes the asset class is overvalued.

Faced with lower growth and inflation, investors have further increased overweight positions in four global sectors: healthcare, telecoms, utilities and consumer staples since November. Around 44% are overweight in pharmaceuticals and 33% are overweight in consumer staples.

Meanwhile, equity allocations towards emerging markets have fallen to their lowest level since 2001. A net 17% of the respondents are underweight emerging market equities compared to a net 6% in November.

ôIt would now be a major surprise for global fund managers if emerging markets were to outperform US equities in 2009,ö says Michael Hartnett, chief emerging markets equity strategist at Merrill Lynch.

China remains by far the preferred choice of Asian equity investors and emerging market specialists. A net 50% say they would want to be overweight in Chinese equities; this is despite the fact that eight out of 10 fund managers expect the Chinese economy to slow in 2009.

ôIronically, the slowdown is indirectly making investors more bullish on China,ö Hartnett says, ôthanks to the promise of policy stimulus and falling commodity prices.ö

The survey was conducted with the help of market research company Taylor Nelson Sofres (TNS). The survey measures net responses by taking the balance between the bullish and bearish views for each survey question.