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LONDON (Thomson Financial) - Investors are finally conceding that a global recession is on the horizon, if it is not here already, Merrill Lynch's January survey of fund managers revealed.

The survey showed 19 pct of respondents now believe a global recession is either likely or very likely over the next 12 months, while the percentage of those who feel a recession has already started doubled to 8 pct from 4 pct in December.

This is a marked change from recent months, where investors had expressed fears of a slowdown rather than an outright recession.

"The period of denial, by some investors, that the credit crunch could have serious repercussions for the real economy may be over," said David Bowers, independent consultant to Merrill Lynch.

"This month's survey shows an evolution of expectations from fears of a slowdown to fears of a major recession," he said.

Notably, whereas in previous months investors had consistently highlighted credit risk as the greatest threat to global stability, they are now perceiving business cycle risk to be equally significant.

At the same time, the vast majority of fund managers expect corporate profit margins to shrink in 2008. A net 77 pct of those polled expect profits to grow by less than 10 pct in the next 12 months, compared with a net 66 pct in December and just 39 pct in October.

Although investors remain reluctant to switch away from their overweight stance on equities and underweight stance on bonds, there are clear signs that asset allocators are starting to make significant adjustments to reflect the risks to the global economy.

The number of asset allocators who are overweight equities tumbled to a net 6 pct in January from 20 pct in December, while the number who are underweight bonds fell to a net 28 pct from 40 pct in December.

There has also been an "aggressive shift" into cash over the past two months, with a net 32 pct of respondents overweight cash in January, compared with 26 pct in December and 20 pct in November.

Investors are particularly pessimistic about the outlook for Europe, where the strong euro and European Central Bank president Jean-Claude Trichet's persistently hawkish stance on interest rates likely to be the main factors weighing on sentiment.

A net balance of 80 pct of European fund managers expect the euro zone economy to weaken in 2008, while a net 80 pct also expect weaker earnings growth in the coming year, both the most bearish since the survey began over a decade ago. Only 4 pct are anticipating double-digit EPS growth in 2008.

Notably, investors do not concur with Trichet's apparent conclusion that the risks of higher inflation outweigh the downside risks to the economy. Three months ago, Merrill's survey showed a net 36 pct of investors expected higher inflation in Europe in the coming year, but this has now fallen to zero. As a result, a net 28 pct believe monetary policy is too restrictive.

"While arguments to be bullish on European equities persist, it is clear that investors are bracing themselves for a raft of earnings downgrades," said Karen Olney, chief European equities strategist at Merrill Lynch.

She noted, however, that the downside is limited, given that European markets have priced in earnings "falling 57 pct of the way to the trough".

Accordingly, the survey showed investors have slashed their holdings in industrials to underweight and "to levels consistent with the May 2006 period of panic", instead moving back into healthcare and oil and gas. They continue to be overweight on banks, which are still seen as a "value trap", Merrill said.

Financials and consumer discretionary (such as retail) are the only sectors recording a net underweight position in January, while the most overvalued sector is seen as global materials and the most undervalued is the pharmaceutical sector.

Meanwhile, on a regional basis, global emerging markets remain firmly in favour, with a net 17 pct of investors expecting to be overweight on the region over the coming 12 months. Emerging markets are also seen as the area where corporate profits are most favourable, with a net 47 pct of investors expressing this view.