Merrill Lynch’s Survey of Fund Managers for August finds that fund managers are reluctant to abandon equities, notwithstanding recent market turbulence.

“While fund managers have turned more risk averse in light of global market instability they still believe equities offer value, especially relative to bonds,” it says. In the broadest snapshot of global institutional investor sentiment since the sharp rises in credit spreads and equity market volatility, a net 11% still regard equities as undervalued, Merrill reports. In contrast a net 41% think bonds are overvalued.

Investors, polled at the height of recent volatility, have increased their cash levels one percentage point to 4.4% of their portfolio, it said. They have trimmed their expectations of corporate profits and expect global growth to slow, Merrill added. “But what is striking this month is how few investors (7%) think a recession is likely in the next 12 months,” it said. “The survey suggests that investors have not rushed to reassess the prospects for equities.”

“Investors seem to be viewing this turmoil as a potential buying opportunity for equities,” said David Bowers, independent consultant to Merrill Lynch. “They appear unwilling to turn fundamentally bearish on equities so long as they believe the rest of the world can decouple from a vulnerable U.S. economy”.

Respondents still appear to view wider credit spreads as a problem centred in the U.S. housing market, and believe that emerging markets are relatively appealing, it noted.

August’s survey indicates a major shift in favour of global emerging market equities at the expense of U.S. stocks. A net 29% of respondents say that emerging markets offered the best corporate profit outlook of all regional sectors — overtaking the eurozone which has been the favoured region throughout 2007. Also, investors believe earnings quality in emerging markets, while a concern, is improving at a time that quality of earnings in the U.S. are deteriorating. Finally, valuations are seen as more attractive. Fewer respondents believe emerging market equities to be the most overvalued. Only a net 8% hold that view while a net 19% see the U.S. as the most overvalued region.

At the global sector level investors still prefer stocks positioned to gain from cyclical trends, despite a more cautious outlook for growth. Globally, the number of surveyed funds overweight technology, for example, has risen by seven percentage points to 33%, from 26% in July. Other cyclical sectors gaining favour include materials, energy and industrials. Meanwhile credit turmoil has hit financials hard. A net 29% of respondents are underweight banks compared with 18% in July.

Europeans share the global sector view despite having reduced their positions in pro-cyclical stocks, Merrill said. “Investors in Europe maintain a pro-cyclical stance, though they have toned down their bet on the cycle,” said Karen Olney, chief European equity strategist at Merrill Lynch. “In the past month they have started to shuffle back into defensives, such as healthcare and food & beverages. This move was overdue, given how extreme the overweights in many of the industrials had become over the past few months.”

For the second month Merrill Lynch asked asset allocators to rate seven potential risks to financial market stability, scoring each risk in terms of the threat they thought it posed to financial market conditions. Credit (default) risk was top of the list for the second month running. A net 78% of the panel thought credit presented an “above normal” threat to economic stability up from 72% last month.

However allocators now regard counterparty risk and business cycle risk as growing threats. More than half of respondents (51%) say that counterparty risk is an “above normal” threat to financial stability – double the score in July of 24%. A net 32% of asset allocators see business-cycle risk as elevated, compared with 8% in July.

A total of 181 fund managers participated in the global survey from August 2 to 9, managing a total of US$599 billion.