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.

Merrill reported that 47% of respondents now expect global core inflation to be higher one year from now. This figure has risen steadily from just 11% in March. The FMS Composite Indicator of Monetary Stance also rose in June, reflecting increased concern among respondents that monetary policy is not yet tight enough to combat inflation. It also noted that 42% forecast higher short-term rates in 12 months’ time (up from 2% in March) and 59% predict higher long-term rates (37% in March). The majority of investors (51%) 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, in a release. “But were rates to rise further they could start to cause problems for equity valuations.”

Indeed, Merrill says that 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% mark, the highest reading in three years, reflecting how for the first time since 2004 the balance of investors 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, as 40% 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% in June from the neutral level of 42% in May, but remains higher than in March. Cash balances remain broadly unchanged at 3.7%, but investment time-horizons shortened appreciably.

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, Merrill said. “What has emerged in June, however, is a suggestion that some are backtracking on their bearishness stance towards U.S. Equities,” it noted. “This could reflect a change of heart towards the U.S. dollar with a net 12% of allocators now viewing the dollar as overvalued, the most positive dollar outlook since 2004. Meanwhile, 64% believe that the yen is undervalued at a time Japanese equities are strongly in favour, and 56% say sterling is overvalued at a time UK equities are out of favour.”

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% in 2008 from 3.2% in 2.7.

“Inflation poses the biggest risk to global growth and that risk is higher than the market is currently pricing,” says 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 7. They manage a total of US$689 billion.