Investors Braced for Higher Rates as Inflation Fears Hit Home

LONDON and NEW YORK,— Institutional investors have become increasingly worried about inflationary pressures and are bracing themselves for higher long-term and short-term interest rates, according to Merrill Lynch’s Survey of Fund Managers for June.

The FMS Composite Indicator of Growth Expectations rose to 43 in May from 33 in April, fuelled by a more positive outlook on economic growth and corporate profits. The net balance of respondents expecting the global economy to strengthen improved from minus 29 percent in April to minus 18 percent in May. Investors are less worried about the outlook for corporate profits where the net balance of respondents expecting profits to rise climbed from minus 32 percent to minus 12 percent. Furthermore 35 percent of the panel now expects double-digit earnings growth over the next 12 months, up from 25 percent in April.

A net 47 percent of respondents now expect global core inflation to be higher one year from now. This figure has risen steadily from just 11 percent in March. The FMS Composite Indicator of Monetary Stance rose to 67 in June from 63 in May and 56 in March, reflecting increased concern among respondents that monetary policy is not yet tight enough to combat inflation. A net 42 percent forecast higher short-term rates in 12 months’ time (up from 2 percent in March) and a net 59 percent predict higher long-term rates (37 percent in March). The majority of investors (a net 51 percent) expect long-term rates to rise more than short-term rates, resulting in a much steeper yield curve.

“Despite the recent back up in bond yields, asset allocators remain overweight equities and underweight bonds,” said David Bowers, independent consultant to Merrill Lynch. “But were rates to rise further they could start to cause problems for equity valuations.”

Equity Valuations Under Threat
The abrupt change in interest-rate outlook has already prompted investors to question equity valuations. The FMS Indicator of Equity Overvaluation highlights how valuations are coming under pressure. The Indicator has broken through the 50 percent mark, the highest reading in three years, reflecting how for the first time since 2004 the balance of investors (a net 4 percent of respondents) believes that equities are overvalued.

Nonetheless, despite acknowledging that equities represent poorer value today than in recent months, investors are by no means ready to overhaul their portfolios with a big switch to fixed income. Most investors believe that equities still offer better value than bonds. A net 40 percent believe bonds are overvalued.

The survey also highlights how inflationary pressure and higher bond yields have yet to have a major impact on global investors’ risk appetite. The FMS Risk Appetite & Liquidity Composite fell two points to 40 percent in June from the neutral level of 42 percent in May, but remains higher than in March. Cash balances remain broadly unchanged at 3.7 percent, but investment time-horizons shortened appreciably.

Investors Review Bearish Stance on U.S. Equities
Asset allocators have yet to respond to the more challenging market outlook, retaining a preference for eurozone equities, followed by emerging markets and Japanese equities. What has emerged in June, however, is a suggestion that some are backtracking on their bearishness stance towards U.S. equities. This could reflect a change of heart towards the U.S. dollar with a net 12 percent of allocators now viewing the dollar as overvalued, the most positive dollar outlook since 2004. Meanwhile, 64 percent believe that the yen is undervalued at a time Japanese equities are strongly in favour, and 56 percent say sterling is overvalued at a time U.K. equities are out of favour.

Global Economy Can See Off Inflationary Threat
Merrill Lynch shares investors’ concern that inflation could pick up, but does not believe that prospects for global growth outside the U.S. are under threat. The bank forecasts non-U.S. inflation to rise to 3.4 percent in 2008 from 3.2 percent in 2007.

“Inflation poses the biggest risk to global growth and that risk is higher than the market is currently pricing,” said Alex Patelis, head of International Economics at Merrill Lynch. “However we feel very comfortable that the economies outside the U.S. will not slow substantially in the remainder of 2007.”

Merrill Lynch believes that the global phenomenon of decoupling between the economies of the U.S. and the rest of the world, which it first highlighted in 2006, is becoming more pronounced. The bank is more bearish than most on prospects for the U.S. economy and more bullish than consensus about the rest of the world.

A total of 201 fund managers participated in the global survey from June 1 to June 7, managing a total of U.S. $689 billion. A total of 180 managers participated in the regional surveys, managing U.S. $462 billion. The survey was conducted with the help of market research company Taylor Nelson Sofres (TNS). Through its international network in more than 50 countries, Taylor Nelson Sofres provides market information services in over 80 countries to national and multi-national organizations. It is ranked as the fourth-largest market information group in the world. Survey results were analysed by David Bowers, who is joint managing director of Absolute Strategy Research Ltd, a financial services consultancy.