Merrill Lynch’s Survey of Fund Managers for September finds that turmoil in the credit markets is starting to feed through into equity market fundamentals, but investors have yet to radically shift their portfolios in response.

Risk aversion has risen sharply, with investors holding cash levels of more than 4.3%, and shortening their investment horizon to an extent not seen since March 2003, it reports. A net 34% described liquidity conditions as ‘negative’ in September, just two months after being seen as ‘positive’ by a net 75%.

Growth expectations are deteriorating and concerns of monetary policy being ‘too stimulative’ have diminished, it says. Business cycle risk has emerged as a significant threat to market stability according to fund managers, with 61% saying this risk is above normal, up from 32% in August.

“Investors say they are worried about business cycle risk, but asset allocators have yet to start reshaping their portfolios for a different environment,” said David Bowers, independent consultant to Merrill Lynch. “This begs the question of whether they are in denial about the possible extent of this downturn.”

September’s survey suggests that, while market conditions have deteriorated, investors have not been pushed into rethinking their preference for stocks over bonds. Investors believe that equities are undervalued, suggesting they sense a buying opportunity within months, Merrill notes.

The mean equity weighting has fallen only three percentage points since July to 53%. A net 23% of investors said they view equities as undervalued, up from 11% in August. Furthermore, a net 37% of asset allocators say they would increase their equities exposure – up from a net 29% who expressed the same view in August. Two thirds of asset allocators remain underweight bonds.

Respondents continue to favour emerging markets and eurozone equity markets in the middle of the market upheaval, while shunning U.S. and British stocks, Merrill adds. A net 36% of allocators are overweight emerging markets equities, and 37% are overweight eurozone equities. Allocators have become less positive about Japan’s prospects because of the stronger yen and doubts over economic recovery, as 14% are now underweight Japanese equities compared with a net 8% being overweight in August.

“One paradox that emerged from September’s survey, was how investors retain a preference for what have traditionally been pro-cyclical stocks, while at the same time expressing concerns that business cycle risk is increasing,” Merrill says, noting that their three most preferred sectors are industrials, energy and technology.

Global concerns about short-term prospects are also evident in the eurozone, where 45% of respondents expect growth to slow and no-one expects double-digit profits next year, Merrill finds. It says investors have slashed holdings in credit or interest-rate sensitive sectors such as banks, autos and construction. However, a net 27% still remain overweight insurance, even though global investors are underweight.

Merrill Lynch’s own analysts, too, are more cautious. The September Merrill Lynch Analyst survey’s measure of sentiment has fallen below 50 for the first time since November 2006, when the survey was created.

“The outlook for earnings momentum has taken a short-term tumble as analysts worry about escalating input and borrowing costs,” said Karen Olney, chief European equity strategist. “But such is belief in the strong structural growth story to the East, that expectations for growth for next quarter are up – not down.”

A total of 188 fund managers participated in the global survey from Sept. 7 to 13. Combined, they manage US$615 billion in assets.