November 17, 2010

As Investors’ Risk Appetite Grows, a Correction Looms, BofA Merrill Lynch Says

Low cash levels: Harbinger of an imminent correction

Investors embraced riskier assets after the resumption of quantitative easing (QE), but a correction could be drawing near, according to the BofA Merrill Lynch Survey of Fund Managers for November released Tuesday.

A net 35% of investors see the global economy strengthening in the next year, compared with 15% a month earlier. A net 41% expect corporate profits to rise by 10% or more in the same period. This constructive outlook has left a net 41% of fund managers overweight equities, up from 27% in October. Their investment strategies have now risen to a normal level of risk-taking, compared with a net 33% reporting below-normal stances as recently as September.

At the same time, the survey reveals increased concern over inflation and warning signs of a potential near-term market correction. The number of global investors overweight in cash has reached a seven-year low as more focus on the near term. A net 30% say their investment time horizon is shorter than normal, up from 25% a month ago.

“Following QE2, we have witnessed a capitulation into risk assets to a degree that history suggests should prompt concern,” Gary Baker, head of European equities strategy at BofA Merrill Lynch Global Research, said in a statement. “Cash holdings, especially, are dangerously low at 3.5% of portfolios.”

Michael Hartnett, the firm’s chief global equity strategist, suggested in the statement that the year-end rally may already have occurred, “leaving investors vulnerable to event risk such as a deepening European sovereign debt crisis or a dollar rally.”

According to the study, investors and asset allocators have headed into positions that take advantage of and protect against higher inflation. November’s survey shows significant shifts into equities and commodities.

The proportion of investors expecting inflation to rise in the next 12 months has spiked to a net 48%, up from a net 27% in October. A net 45% believe that global monetary policy is “too stimulative,” after the second round of quantitative easing by the U.S. Federal Reserve.

A net 41% of asset allocators were overweight equities this month, up from a net 27% in October and a climb of 31% since September.

Allocations to global emerging market equities have continued to rise; in November, they reached their highest level in nearly seven years. A net 56% of the panel is overweight this sector, up from a net 32% just two months ago.

Commodities have also grown in popularity with a net 21% of asset allocators overweight the asset class, compared with 17% a month ago. As well, investors have increased their equity allocation to basic materials stocks with a net 21% overweight the sector, up from a net 9% in October.

In contrast, allocations to bonds slipped further with a net 36% of the panel underweight bonds in November, up from a net 24% in October.

According to the survey, more than one-third of global investors have identified EU sovereign funding as their key risk. Concern about the public finances of several EU member states is reflected in a cautious outlook for the European economy. A net 23% of European respondents expect the region’s economy to strengthen in the coming 12 months. This represents a more muted pickup in outlook than elsewhere except China, where a net 16% of respondents now expect a stronger economy, down from October’s 19%.

Overweight positions in euro zone stocks increased in November to a net 15% of investors, up from October’s net 3%. But the proportion of investors who named the region as their top pick for underweighting in the next year also rose to a net 12%.

A total of 218 fund managers, managing $634 billion in aggregate, participated in the global survey from Nov. 5 to Nov. 11. A total of 170 managers, managing $419 billion, participated in the regional surveys. The survey was conducted by BofA Merrill Lynch Research with the help of market research company TNS.

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