One of the more surprising findings of Merrill Lynch global fund managers' survey this month was that fund managers remain quite cyclically exposed, in spite of growing concerns about a deterioration in the global economy in 2005.

A net 25 per cent of fund managers expect the global economy to weaken over the coming year and 23 per cent think the global profit environment is deteriorating - the most pessimistic picture the managers have painted since the spring of 2001.

Nonetheless, they retain net overweight positions in energy, basic materials and industrials.

This prompts the question: why are investors not buying defensive stocks? Instead global fund managers are underweight in pharmaceuticals, utilities and staples.

One factor lies with the lack of volatility and exceptionally tight trading ranges which have characterised equity markets throughout this year.

A result of this is that the spread between (forward) price earnings ratio's for pan-European cylical and defensive sectors has narrowed significantly between 2004 and 2005.

Chemicals is trading on a 2005 PE ratio of 11.6, basic resources 11 and construction 11.3.

Meanwhile defensives like utilities are trading on 11.7, personal care & household goods 12.5 and food and beverages on 13.7.

So although global growth is expected to slow, the valuation arguments for buying defensives or selling cylicals have not become compelling.

The clearest sectoral distinctions from Merrill's survey were that a net 37 per cent of fund managers thought tech stocks were overvalued while 18 per cent said pharmaceutical stocks were undervalued. However, apart from these two preferences, it is difficult to discern a clear sense of any sectors moving into significantly over-valued or undervalued territory over recent months.

Peter Oppenheimer, global strategist at Goldman Sachs, expects the European equity market to continue to trade in a relatively narrow range over the next six to nine months. “We would not advise a sector strategy based on traditional notions of cylicality or defensiveness,” he said.

The problem with attempting to draw a clear distinction between cyclicals and defensives is that many sectors are facing changing competitive dynamics that are rendering their cyclical characteristics as less useful a guide to performance.

Instead Goldman advises investors focus on four main themes: seek sectors with the potential to generate secure cash returns for investors (high yield and high cash flow companies) and sectors which can benefit from the contunuing strength of China. But avoid consumer-facing industries and those companies likely to face more margin pressure.

The importance of high yield and cash flow was also reflected in Merrill's survey which found 46 per cent of fund managers wanted companies to return cash to shareholders rather than increase capital spending.

The strength of the Chinese economy means that cyclical sectors such as mining or providers of infrastructure solutions are facing an extended cycle of demand.

More defensively orientated consumer sectors usually outperform as economic growth momentum slows, but analysts remain uncertain about the impact of any slowdown in consumer spending next year.

Companies like Unilever, the global consumer products group, has already found maintaining growth rates for key brands challenging.

Companies facing margin pressure are found in both the cylical and defensive sectors. Airlines are one of the most obvious examples of a sector which could suffer from a slowdown in consumer spending and higher jet fuel cost. Car makers are expected to suffer from increasing input costs from higher commodity prices. However, defensive utilities will struggle to pass on higher costs from record crude oil prices to consumers.

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