Investors surveyed by Merrill Lynch are more optimistic about economic growth than they have been since December 2005, but the uncertainty over the banking crisis in the US is preventing them from putting their cash into equities.

For the first time in more than three years, investors do not predict lower global economic growth over the next 12 months, according to Merrill Lynch's March survey of fund managers. A bullish outlook over China continues to drive their overall optimism. Just two months ago, a net 70% of the respondents thought China's economy would worsen in the year ahead. That figure fell to a mere 1% this month.

Simultaneously, risk appetite has dropped with investor pessimism towards banks at a record high. A net 48% of asset allocators say they are underweight banks this month, up from a net 39% in February. A total of 22% say they are aggressively underweight banks, versus 17% in February. Respondents are also decidedly bearish about Japanese and eurozone equities.

"March's survey shows signs that investors want to believe in an economic recovery. However, caution on banks is firmly capping risk appetite," says Gary Baker, Banc of America Securities-Merrill Lynch co-head of international investment strategy.

How investors resolve this anomaly between growth optimism and risk reluctance will determine the fate of equity markets in the coming months, says Michael Hartnett, also a co-head of international investment strategy at the firm.

Risk appetite in equities took a marked downward turn in March despite the improved economic outlook. Respondents say they have reduced their equity exposure in the past month while increasing cash holdings and fixed-income investments.

A net 41% of respondents are underweight equities, up from a net 34% in February. World equities fell by 15.5% during the days the survey took place. Investors appeared to have flooded into bonds with a net 26% of the respondents overweight that asset class, up sharply from a net 7% the previous month. Average cash balances rose to 5.2% from 4.9% in February.

Signs of an early recovery phase have appeared, however, according to Merrill Lynch.

A net 42% of the respondents believe equities are undervalued, up from a net 24% in February. Changes in sector allocation indicate a movement out of the most defensive stocks, such as pharmaceuticals -- where a net 30% are now overweight the sector, down from a net 37% in February. The respondents have also increased exposure to technology, a much more cyclical industry. A net 28% of respondents are overweight the sector, up from a net 15% in February.

While the US continues to fuel economic optimism, investors have become more bullish about emerging markets, especially China.

Respondents have taken a net overweight position in emerging markets equities for the first time since August 2008. A net 4% are overweight the region compared with net 4% underweight in February. Commodities have made further gains with the number of investors underweight the asset class falling to a net 6%, down from a net 25% in January.

"Optimism on growth has been expressed with higher weightings in emerging markets equities and commodities," says Hartnett.

In contrast, investors have further reduced equity investment in the eurozone and Japan. A net 40% of respondents are now underweight eurozone equities and a net 39% are underweight Japanese equities.

"Investors might look to review their extreme underweight positions in eurozone and Japanese equities if economic data follow growth expectations higher," notes Hartnett.

A total of 213 fund managers with a combined $533 billion in assets under management participated in the global survey from March 6 to March 12. A total of 183 managers, managing $365 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 measures the net responses of the respondents.