Fund managers have taken their most negative stance towards equities in a decade, with a net 27% underweight in the asset class in June, according to the latest monthly Merrill Lynch survey.

ôInvestorsÆ fears of stagflation have crystallised as they face up to the possibility that interest rates might have to rise as the global economy slows,ö Merrill Lynch says.

Fund managers have acted by reducing exposure to both equities and bonds and moving into cash.

This monthÆs survey reflects a world where global growth and profit expectations are deteriorating while fears of higher inflation, and subsequent higher interest rates, are rising. Just 1% of respondents believe equities are undervalued, down from 25% in March. A net 81% of the panel believes consensus earnings estimates for the next 12 months are too high. A net 42% of asset allocators are overweight cash, up from a net 31% in May.

ôThe market is waking up to the idea that global interest rates are too low, in fact they remain below inflation,ö says Karen Olney, chief European equities strategist at Merrill Lynch. ôNegative real rates are hardly an antidote to inflation.ö

Merrill Lynch expects a double rate hike from the European Central Bank (ECB) by October and expects other central banks to follow.

Europe has taken the brunt of investorsÆ shift away from equities. Over the past 12 months, the Eurozone has moved from most favoured to least favoured. A net 29% of investors say the Eurozone is the region they will most likely underweight on a 12-month view.

Asset allocators have already moved aggressively out of Eurozone equities. A record net 22% say they are underweight û the most negative stance taken in the past 10 years. Not only has the Eurozone the least favourable corporate profit outlook, but the quality of earnings have been slipping too. This, in turn, is reducing any perceptions that Eurozone equities are undervalued. Also fuelling their negative stance are concerns about the currency. A net 71% of asset allocators believe that the euro is overvalued û a particular concern for a region heavily dependent on exports.

Amid these concerns, European fund managers have been moving into cash. A net 34% of European investors said they were overweight cash in JuneÆs regional survey, up from 3% in April. A growing number recognises that higher interest rates are likely. In February, half of European respondents believed ECB monetary policy was too restrictive. That number fell to a net 10% this month.

The credit crunch is losing its sting as the greatest single threat to financial market stability. The net percentage of investors citing ôcredit riskö as the number one threat has fallen from 95% three months ago to 81% in June. But inflation is the fastest growing concern. A net 65% of respondents cite ômonetary riskö as the greatest threat, up from a net 23% in May.

ôFor the first time in our memory, inflation, not growth is the primary macro driver at the global level, in our view. The inflation shock has already happened,ö says Alex Patelis, head of international economics at Merrill Lynch. ôWhat matters now is how persistent it is and how markets and policymakers react; at a global level this begs for an accident that will awaken markets and policymakers to the risks.ö

A total of 204 fund managers participated in the global survey from June 6-12, managing a total of $718 billion. 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.