Fresh optimism over China’s growth prospects has led to an improvement in economic sentiment, according to the latest Merrill Lynch Survey of Fund Managers.

The latest version of the institutional investor survey finds that investors are at their most hopeful about the year ahead since the credit crunch took hold in July 2007, with the number who forecast a worsening economy in the 12 months ahead falling to just 6% from 24% in January. The majority recognizes, however, that the world economy is in recession, it adds.

Merrill says that fears of a prolonged slowdown in China appear to be fading. The number of investors who predict lower growth in China over the coming 12 months has fallen sharply, to 21% in February from 70% in January.

Similarly, severe pessimism about the outlook for corporate earnings has started to ease, it says, adding that 43% of respondents expect to see deteriorating profits over the coming year, significantly lower than the 63% who held that view in December. Also, 49 % of the panel predicts inflation will fall over the coming 12 months, compared with 64% in January and 82% in December.

“Fund manager expectations for Chinese economic growth rose dramatically to their highest levels since 2007, and faint global decoupling hopes now reside solely with China,” says Michael Hartnett, chief global emerging markets equity strategist at Banc of America Securities-Merrill Lynch Research.

The survey also finds that commodities have enjoyed the sharpest pick-up in terms of changes to asset allocations in the past two months. Investors still hold a net 15% underweight position in commodities, down from 32% underweight in December.

Bond weightings were trimmed while equity allocations fell back to a net 34% underweight, it reports, adding that investors have been pruning back their allocations to traditional defensive sectors and moving into more cyclical sectors. It notes that weightings fell in telecoms, insurance, staples and utilities. At the same time investors increased positions in technology, energy, materials, industrials and discretionary spending.

“Higher risk appetite, rising commodity sentiment and a strong valuation case could encourage further investment in energy and materials sectors. We see this as best played out through sterling-denominated assets,” said Gary Baker, Banc of America Securities-Merrill Lynch head of EMEA Equity Strategy.

The survey also found that investors’ appetite for U.S. equities has been reawakened in February, possibly boosted by poor market performance in January. The net overweight position in U.S. equities has risen to 15% this month, up from 7% one month ago. The U.S. benefits from having the best profits outlook, and 31% of respondents want to overweight U.S. equities in the next 12 months.

At the same time allocations to Japan have fallen starkly with investors who hold a net underweight position of 26%, compared to 15% in January. Traditionally, Japanese equities would benefit from a broad pick-up in sentiment, it notes. Japan also suffers from having an overvalued major currency, according to the survey.

For the first time, respondents view the yen as more overvalued than the euro. Pessimism over the euro has broadly moderated, while the region’s macro-economic outlook is somewhat more favorable. “Eurozone growth expectations picked up to the highest level in 12 months in February,” said Baker. “But in contrast with the global picture, the number of European portfolio managers overweight cash spiked to the highest level since October 2001.”

A total of 212 fund managers, managing a total of US$599 billion, participated in the global survey from Feb, 6 to 12.