Global fund managers have embraced riskier assets since the US Federal Reserve announced a second round of quantitative easing worth $600 billion earlier this month, the November BofA Merrill Lynch Fund Manager Survey showed.
Polling 218 fund managers, who manage $634 billion in assets, in the week following the Fed’s QE2 announcement, the survey revealed that market sentiment was more bullish in November than at any other time since April of this year, thanks in large part to the removal of uncertainty regarding US fiscal policy. Sentiment among asset allocators is one of high-optimism, pro-growth, and pro-cyclicals survey, summarised Gary Baker, head of European Equities strategy at BofA Merrill Lynch Global Research, adding that expectations have undergone a radical shift following QE2.
However, the survey also indicates investors could be increasingly vulnerable to external shocks, such as the deepening European debt crisis or a deflationary rally in the US dollar. In fact, BofA Merrill Lynch analysts believe that either the historical end-of-year market rally has already taken place, or that it could be subdued due to investor exposure to such pressures.
Global Growth Expectations on the Rise
As developed economies continue to muddle their way through the recovery and emerging markets continue to go from strength to strength, institutional investors are becoming increasingly optimistic about the economic outlook. A net 35% of global managers surveyed now forecast stronger global growth over the next 12 months—a notable improvement compared with only 15% who took that stance in October.
Investors are increasingly convinced of a “liquidity-driven boom” and this is particularly clear in the positions they have taken in emerging markets. Overall rotation of assets into emerging markets as a whole is approaching historical peaks: this month a net 56% of global asset managers have overweight holdings in GEM equities—just one percentage point lower than the highest proportion ever recorded by the survey back in April 2004. The survey shows that there has been a marked surge in appetite for GEM financials so that asset managers are now the most overweight they’ve been in this sector since July 2007. This increase in appetite for what are traditionally considered higher risk areas is exemplified by the BofA Merrill Lynch’s Risk and Liquidity indicator, which has climbed higher above the long-term average of 40 to 45 in the latest survey versus 43 in October.
Looking at sectors from a global perspective, asset allocators have shown a clear move from defensives to cyclicals. Investors rotated aggressively into materials (from 9% overweight in October to 21% overweight in November), and out of consumer discretionary, pharmaceuticals and industrials.
Potential Post-QE2 Correction
In spite of this resurgence in optimism, a number of indicators produced by the latest survey could be viewed as predicating a correction going forward. While the balance of assets allocated between equities and bonds shows a clear preference for equities, in line with managers’ predominant appetite for risk and the Fed’s agenda to underpin economic and market growth, the survey shows that cash reserves have been drained dramatically, with a rare net underweight of 5% and the average cash holding falling to 3.5% of the total portfolio. Such low cash levels have triggered BofA Merrill Lynch’s contrarian tactical sell signal, which in the past has tended to be followed by a negative market trend.
However, BofA Merrill Lynch’s Gary Baker pointed out that, with QE2 influencing risk and liquidity expectations, historical technical analysis trends can be distorted. It was only this week that actual cash from the Fed was injected into the market alongside a very clear signal that the US government will be driving investors towards other asset classes by taking US Treasuries off the market.
Elsewhere, Chinese growth expectations showed an “intriguing decline”, with 16% of global fund managers forecasting economic growth in the region over the next year compared to 19% last month. Chinese growth expectations can be viewed as an indicator of upcoming changes in global growth sentiment,, said Baker.
Eurozone Outlook in the Balance
While Eurozone equities also enjoy their largest overweight rating since April 2004, with net 15% overweight the region this time round versus just 3% last month, the positive trend is a consequence of overall positive sentiment, Baker explains. There is only so much interest investors can allocate to GEM, he adds.
In contrast to most other regions, the macro outlook for Europe barely improved on the back of QE2. Only 23% of European regional fund managers now anticipate the economy will strengthen over the upcoming 12 months, up from 20% in October. In comparison, growth expectations jumped by 24 percentage points to 65% in the US and by 35 points to 41% in the Pacific ex-Japan.
The Weight of Peripheral Debt Worries
“European sentiment is probably being held back by worries over EU sovereign debt funding, which is now seen as the biggest ‘tail risk’ by survey respondents,” the BofA Merrill Lynch global research report said. This month 34% of the surveyed global asset managers indicated peripheral Europe fiscal troubles as the biggest tail risk, up from 21% in October.
However, asset allocation data still points to risk appetite on European equity markets. Unlike macroeconomic growth expectations, sector preferences in Europe are similar to these in the rest of the world. For the first time in a long while investors have rotated strongly into eurozone resources and cyclicals. Overall, six out of the eight sectors the survey points to as being overweighted are cyclical, and just one is defensive. In addition, the size of the average sector overweight has jumped after several months of stagnation. Basic resources is the biggest winner, with a 27% month-on-month increase in the number of managers who are overweighting the sector–significantly above its long term average.
There is little evidence that debt concerns in peripheral Europe are spilling over into core European equity markets just yet, says Gary Baker. The potential negative impact of another bailout in Europe is limited compared to earlier this year, he explains. Investors were startled by the Greek crisis this February, when peripheral debt concerns spiked for the first time and there was no clarity on how the matter may be contained. However, bailout blues weigh less on investors’ appetite today. The fact that, since February, individual member states have made pledges to address their debt situations and a EUR 750 billion rescue fund has been agreed, in addition to the Fed’s liquidity injection, are responsible for minimising the negative impact.
In contrast to other less sanguine opinions, Baker believes that it at this point there cannot be talk of debt worries threatening to bring down the entire EU edifice.
An Empty Christmas Stocking?
While the impact of a potential Irish bailout might be less substantial than the pressure February’s Greek crisis put on European equity markets and, as Baker points out, currency dynamics have been relatively orderly, concerns over the eurozone recovery remain.
“It’s possible that the year-end rally has already happened, leaving investors vulnerable to event risk such as a deepening European sovereign debt crisis or a dollar rally,” said Michael Hartnett, chief Global Equity strategist at BofA Merrill Lynch Global Research.
