Pessimism about prospects for economic growth and corporate profits has deepened among global investors but they are keeping faith with the idea that the rest of the world can decouple itself from the US housing crisis, according to Merrill Lynch's Survey of Fund Managers for December.

Fund managers are sticking to an investment strategy which regards stocks as cheap relative to bonds. They believe the rest of the world economy can decouple itself from the US mortgage crisis, and they continue to favor "growth" assets like emerging markets over "value" assets such as financial services.

For much of the year the strategy has worked well. However, since June, stock returns have lagged bond returns, and over the past six weeks some of the global sectors exposed to emerging-market economies, such as industrials and basic materials, have underperformed.

A net 60 per cent of fund managers now expects corporate profits to deteriorate in the next 12 months - the most pessimistic response in almost a decade - while a net 62 per cent  expects the global economy to weaken. "Pessimism about the global economic outlook suggests that 2008 could be the year that the decoupling thesis faces its sternest test," said David Bowers, independent consultant to Merrill Lynch.

Fears over corporate profit outlook grow
Earnings growth is set to become a scarcer commodity, with 80 per cent of respondents taking the view that corporates are unlikely to see double-digit profits growth over the coming 12 months.

Cost cutting is expected to be the primary source of earnings growth that companies achieve as the business cycle becomes increasingly mature; 74 per cent of the panel now believe the world economy has entered the late-cycle phase versus 62 per cent in September. However, while expectations for economic growth and corporate profits in December are among the most pessimistic the survey has recorded, only 13 per cent  of respondents expect an outright global recession in 2008.

Investors' love affair with emerging markets continues despite a sharp rise in the number of fund managers expecting a slowdown in China's economic growth. A net 25 per cent  of respondents expect the Chinese economy to weaken in 2008. Only 4 per cent  in took this view in November.

Investors' enthusiasm for European equities wanes
A net 19 per cent  of respondents are overweight eurozone equities, sharply down from 50 per cent  six months ago, with the UK. hardest hit. The net balance of asset allocators underweight UK. equities rose to 26 per cent  in December - one of the most bearish stances taken on the UK market - amid growing concern that sterling is overvalued.

"Germany's status as the world's largest exporter leaves investors feeling exposed. To avoid getting caught in the crossfire between a spiraling euro and slowing global growth investors go domestic," said Karen Olney, chief European equities strategist at Merrill Lynch. "Over twice as many investors prefer domestic, versus overseas, growth. They have battened down the hatches and moved into defensive, domestic growth, such as telecoms and personal and household goods and utilities."

Government bond bright spot
Despite all these concerns, asset allocators still prefer equities over bonds. A net 13 per cent  of the panel think equities are undervalued while a net 43 per cent  believe bonds are overvalued.

"Continental European bonds could remain constrained though a lack of action from the ECB," said Andrew Roberts, chief European fixed-income strategist at Merrill Lynch. "However elsewhere we think government bonds are a great investment in 2008, as the US and the UK lead the way to lower yields and strong returns, driven by weakening economies, rate cuts and a liquidity crisis that is here to stay."

Investors remain surprisingly relaxed about inflation. A net 15 per cent  expects global core inflation to rise next year, down from 35 per cent  in November.

A total of 195 fund managers participated in the global survey from December 7 to December 13, managing a total of $689 billion. A total of 172 managers participated in the regional surveys, managing $439 billion. The survey was conducted with the help of market research company Taylor Nelson Sofres (TNS) and the survey results were analysed by David Bowers, who is joint managing director of Absolute Strategy Research Ltd, a financial services consultancy.