Fund managers have turned more optimistic about the outlook for the world economy compared to six months ago, but they cautioned that recovery is likely to be modest and may only kick in next year. In other words, the strong optimism exuded by some green shoot theorists, as evidenced by the sterling market rally in recent months, seems premature and may be overdone.

SG Asset Management for example, cautioned that while data coming through appears encouraging, economic conditions are still very weak. It said that downside risks are still present and a bumpy and lengthy recovery path lies ahead for the global economy.

Nevertheless, fund managers were of the view that the worst is likely to be behind us, which means that markets are unlikely to re-test their March lows anytime soon.

“The worst-case scenario of global depression and a major systemic crisis that was a serious possibility early this year is now no longer a threat”, said BNP Paribas Asset Management.

“Rising Purchasing Managers Indices, indications that the inventory cycle is beginning to bottom out, the general thawing of the credit markets, fewer banks tightening their lending conditions and a slower contraction in the pace of global activity all lend support to the view that the worst is probably over,” said Schroder Investment Management.

Although the pace of economic decline is slowing, fund managers warned that conditions are likely to remain tough for companies for the rest of this year.

Aberdeen Asset Management said that the weak global demand and economic uncertainty will continue to exert pressure on businesses which are still facing credit constraints.

Allianz Global Investors also cautioned that “economic activities will remain sluggish, leading to corporate profits and margins being lacklustre and labour markets remaining difficult.”

With such constrained expansion, corporate earnings growth is likely to remain weak, at least for the remainder of 2009.

Global equity markets have witnessed a strong rally since March this year and are likely to consolidate in the short-term. Nevertheless, most fund managers remain cautiously optimistic about the outlook for equities over the next six months.

“Global stock markets may not revisit the systemic shocks that caused bourses to plunge earlier this year,” said Lion Global Investors, as aggressive action by governments and central banks have reduced systemic risk significantly.

UOB Asset Management also struck a positive chord. It said that even if the global economy weakens, it is not likely to re-create the level of panic that existed at the beginning of the year.

Whilst UBS Global Asset Management maintains that valuations across equity markets remain attractive, they also caution that the road ahead for equity markets will not be smooth sailing given the potential headwinds in the horizon

ING Investment Management also warned that the risk of sovereign credit downgrades and downward earnings revisions could cause the markets to retreat in the short-term.

According to HSBC Global Asset Management, for a sustainable recovery, there would need to be a stabilization of both economic and volatility indicators.

“Economic activities like exports and manufacturing data would need to reach more normal levels in order to suggest that the markets are starting to improve,” said HSBC.

Other indicators that fund managers keep an eye on are corporate credit spreads, the Volatility Index, the U.S housing sector and the willingness of banks to lend.

Henderson Global Investors sounded a note of optimism when it said that “the continued loosening in credit conditions and signs of improvement amongst leading indicators suggests that a turnaround might have already begun.”

DBS Asset Management was also sanguine about prospects. It said: “A good leading indicator of the economic cycle will be the Purchasing Managers Index, which is starting to rise in most economies. Also, consumers are turning more confident about the future, which bodes well for equity markets.”

Among equity markets, fund managers were generally of the view that the Asia ex-Japan region is best positioned to recover from the present financial debacle.

Ironically, part of the optimism stems from the structural problems faced by the developed countries which could take a long time to correct.

In contrast, the Asia ex-Japan region is on a stronger footing because of “sounder economic fundamentals, healthier government reserves and corporate balance sheets as well as bigger fiscal stimulus packages,” according to Aberdeen Asset Management.

Fund managers also highlighted that the region's large reserves will give its economies the flexibility to boost domestic demand through a mixture of aggressive fiscal and monetary policies. China and India are shaping up to be the key growth engines in the region, and they are likely to outperform other Asian economies this year.

Schroders is also positive on the Asia ex-Japan region because it said that the region does not face the same financial risks as the West as it has already undergone its own de-leveraging process after the Asian financial crisis more than ten years ago.

Within Asia, China has received a lot of interest among investors and its stock market has done exceptionally well.

While the short term outlook is uncertain, Lion Global is positive on China's long term prospects due to “its sturdy economic fundamentals, proactive and competent macroeconomic management, shifting growth model and stable political environment.”

The fund manager also highlighted China's large domestic market and policy flexibility, which it said will allow the country to register the fastest growth amongst world economies.

“The policy style of the Chinese government has helped to boost the confidence of both private investors and households,” said Lion Global.

“China appears to be showing signs of recovery in domestic spending after a slew of aggressive stimulus measures.”

UBS Asset Management is also positive on China, “Long-term growth in China will likely be sustainable because the economy has not reached its full potential and sources of sustainable growth remain intact. The downside risks in the near term are global demand for China's exports, which are beyond the control of the Chinese government. As policy measures take effect, we expect to see more signs of recovery. However, we are cautious on the sustainability of new loan creation that has been driving market sentiment. Furthermore, corporate earnings and the external environment have yet to show substantial improvement, and therefore need to be closely monitored to determine if a solid recovery has taken place”.

Many fund managers were positive about the longer term outlook for commodities, although some warned that prices are likely to be volatile and the sector is vulnerable to weakness in the global economy which impacts end-demand.

Fortis Investments is positive on commodities on a structural basis. It said that the current underinvestment may lead to future shortages, making the asset class attractive for long term investors.

Allianz is also positive on commodities in the longer term and “believes that demand-supply dynamics and an inflationary environment will drive prices higher.”

Within the commodity space, Lion is positive about gold which is a hedge against currency debasement and inflation, and also energy, given the longer term dynamics in demand and supply.

Despite the attraction of equities, some fund managers were also positive on bonds and said that the asset class offered opportunities as well.

“Credit markets have performed well in recent weeks but they still appear cheap, and in our view offer higher compensation for the risk than equities,” said Prudential Asset Management (Singapore) Limited.

Within the bond space, given the presently low yields on many government bonds, most fund managers preferred corporate bonds and in particular, investment-grade bonds. They said that the spreads on investment-grade bonds are still wide relative to historical levels, and on a risk-adjusted basis, these bonds are still attractive.

Fortis Investments thinks that investment-grade bonds give investors ample returns relative to the risk of downgrades or defaults. “Narrowing spreads should lead to their out-performance versus government bonds,” said Fortis Investments.

Phillip Capital Management sees the U.S. housing market as a risk factor that could derail the nascent economic and stock market recovery. “U.S. housing values need to stop declining for the recovery to be convincing,” said Phillip.

HSBC is concerned about the unprecedented amount of liquidity being pumped into economies by central banks around the world, which it reckons could fuel inflation in the longer term.

First State Investments also raised the question about the ability of developed markets to take on more debts in future. This is an important consideration as policy makers may need to undertake more measures to support their economies if the current recession worsens of is prolonged. It warned that if these policy makers do not have sufficient funds to fall back on, this may prevent the green shoots of recovery from blossoming.