Merrill Lynch Fund Managers Survey - August 2011

Note: An overall total 244 panelists with US$718 billion of assets under management participated in the survey from 5 to 11 August. A total of 176 fund managers, managing a total of US$551 billion, participated in the global survey. A total of 136 managers, managing US$359 billion, participated in the regional surveys. The survey was conducted by BofA Merrill Lynch Research with the help of market research company TNS. The survey took place from August 5 to August 11, when world equities fell by 12.3 percent.

Tail Risks

Worsening growth expectations are a major theme in the August survey, with 29 percent of respondents feeling a recession is likely, a rise from 13 percent in the previous month. Investors' forecast for corporate profits shows the biggest downwards swing in the survey's history. A net 30 percent of the panel expects the profit outlook to deteriorate in the coming 12 months. In July, a net 11 percent forecast an improvement in profits.

The biggest “tail risk” seen by the portfolio managers remains European Union sovereign-debt funding. Three-quarters of investors this month identified business cycle risk as the number one risk to market stability -- up from 42 percent in July. The drastic change in investors’ economic outlook signals both an erosion of confidence and a significant degree of uncertainty. This latest survey shows that managers’ investing time horizons have fallen to the most short-sighted level on record.

Inflation expectations fell dramatically, with a net 6% of managers now believing inflation will be lower in the next 12 months. Last month, a net 28% felt it would be higher. Twenty-five percent of the group expects interest rates to rise; 72% thought that last month.

Monthly Questions

Interestingly, only 22% now rule out any prospect of another round of QE against 40% last month. About 60% of respondents think that the Fed would step in at an S&P level of 1,100, which was touched briefly on 09th of August 2011. Last month only 28% of hedge fund managers considered that a level of 1,100 or below would signal a third round of easing.

Asset Exposure

Asset allocators have scaled back equity positions faster than in any previous month in the survey's history, which shows remarkably fast liquidation. A net 2 percent remain overweight equities, down from a net 35 percent in July. A net 48 percent of respondents said equities were undervalued, the record in the survey's history, which indicates willings to eventually buy back in. Global asset allocators have also departed cyclical stocks en masse over the past month.

Allocations towards industrials suffered a negative 27 percentage point change from July to August. A net 16 percent of global allocators are underweight Industrials, compared with a net 11 percent overweight in July. The proportion of respondents overweight energy stocks declined to a net 14 percent from a net 27 percent a month ago, which is a 13 percent drop. While a large majority of allocators remain underweight banks, the month-on-month swing in the sector was a modest 4 percentage points. Fund managers have rotated towards defensives, notably the utilities and food and drink sectors.

Cash holdings have soared to their highest levels since the depths of the credit crisis as investors have moved out of equities, notably cyclical stocks. Cash balances have climbed close to their high of 5.5 percent in December 2008. Global investors hold an average of 5.2 percent of portfolios in cash, up from 4.1 percent in July. A net 30 percent are overweight cash compared with their benchmark. Both numbers are at their highest level since March 2009.

Risk and liquidity premiums fell to 33, which is the lowest level since March 2009. Hedge funds reduced their gearing levels as well. The ratio of their gross assets relative to capital fell to 1.43 from 1.50 last month. Their net exposure to equity markets -- measured as long minus short as a percentage of capital -- rose to 33 percent from 31 percent.

Asset allocators have reduced their positions in the U.S. more aggressively than in any other region and at the sharpest rate the survey has ever recorded. Asset allocators responding to the global survey moved slightly underweight U.S. equities. A net 1 percent of the panel is underweight this month, compared with a net 23 percent overweight in July. Europe, despite the continuing pessimism on economic prospects for the region, did better. The percentage of global managers underweighted to European stocks dropped from 21% in July to 15% in August.

Asset allocators have reduced their overweight position in global emerging market (GEM) equities. A net 27 percent of the global panel is overweight the region, a fall of 8 percentage points month on month. Among emerging markets, Indonesia (+40%) and Russia (+27%), are the most favoured markets though the Russian bet is cut sharply in-line with the reduction in emerging market energy positions. China (+20%) and South Africa (+13) are the other notable overweights, while India (-40%) and Taiwan (-27%) are the least favoured.

Safe haven assets like Government Bonds, showed allocations moved to a net 33 percent underweight from 45 percent, coming closer to the long-run average of net 34 percent underweight. Investors have taken the view once more that Gold is overvalued. In July, the net percentage taking this view dipped to a net 17 percent. But with gold hitting new highs, a net 43 percent of August's panel believes it is overvalued. This reading is highest since the Gold survey started in 2008.

Finally, above average amount of hedge fund managers still remain optimistic on the European currency, but we have not reached any extreme positions just yet.

Personal Summary

My personal take on the current survey is that hedge fund managers are becoming extremely bearish, cutting exposure to risk assets and adding exposure to cash and bonds. Furthermore, inflation expectations have dropped considerably. That is a sign that one should turn contrarian and start expecting inflation to eventually come back again. Let me explain by using this example:

Managers are worried about EU debt crisis, and usually whatever they worry the most about, tends to work out in the opposite direction. Consider that in the April 2011 survey, hedge fund managers were the most worried about commodity inflation, just as the CRB Index as well as Crude Oil were peaking on 02nd of May.

A few months later and the commodity inflation worries have been cut at the fastest pace since the survey started. Therefore, if April 2011 was a great contrarian indicator to reduce exposure to commodities, than today's survey is just the opposite. Keeping all that in mind, while I don't think risk assets have bottomed just yet, I believe we are in the process of doing so over the coming months.

Finally, the potential catalyst to trigger such a rally could be the EU short/medium term fix. The fear is the greatest towards EU problems, and majority of the time these managers (which herd) tend to be wrong. So therefore, from the contrarian point of view, I would look towards Euro-Bonds as possible medium term fix to the problem.