Merrill Lynch’s Survey of Fund Managers for September found that expectations of a global economic recession have risen sharply, and risk aversion has reached a new high.

The survey found that 61% of respondents believe a recession is likely in the next 12 months. Echoing these fears, investors have moved to their most risk-averse mindset yet recorded, it reported.

The firm said that the results, collected after the U.S. Federal Reserve’s takeover of Fannie Mae and Freddie Mac, but before the failure of Lehman Brothers, Merrill’s sale to Bank of America Corp. and AIG’s federal bailout, show that investors have adopted more defensive strategies and shortened their investment time horizons. It also noted that liquidity conditions have worsened, with 39% of respondents rating conditions as negative, double August’s reading. Highlighting the flight to safety, the survey found investors to be overweight bonds for the first time in over a decade.

“Investors care little about inflation with recession on their doorstep and the banking system under pressure,” said Karen Olney, lead European equities strategist at Merrill Lynch, in a release. “They have made it clear that monetary policy is too restrictive and rates need to be cut.”

The survey found that investors rank the eurozone as their least favourite destination, with 50% of global asset allocators underweight Europe, the most negative reading since the survey began. They also say that the outlook for corporate profits is less favourable in the eurozone than anywhere else.

More than two-thirds of European investors predict recession in Europe within 12 months, up from 13% in June. At the same time, they have radically changed their view on inflation as expectations fall to the lows seen in 2001. In June, 32% predicted inflation would rise over the next 12 months, but now 69% expect inflation to fall. Accordingly, appetite for rate cuts by the European Central Bank has increased. Nearly two-thirds of respondents believe Europe’s monetary policy is too restrictive – up from 36% who held that view in August.

“These fears have ricocheted into wild moves in sector popularity. European fund managers are migrating towards lower risk industries — feasting on food & beverages while purging positions in commodities,” Olney said.

The survey also found that hedge funds have become acutely more bearish in equities. Nearly one in four hedge funds surveyed said that they have a net short equities position, compared with 6% who held net short equities positions in August.

At the same time hedge funds are reducing, or being forced to reduce, their leverage. The weighted average ratio of gross assets to debt fell from 1.2 times in August to 1.0 times in September. More than half of respondents to the question have a leverage ratio of less than 1.0 times.

Emerging markets are also now at a record underweight, thanks to falling commodity prices, global growth concerns and residual inflation fears in emerging market economies. Michael Hartnett, chief global emerging markets strategist at Merrill Lynch said, “An improvement in sentiment toward the asset class will arrive once commodity prices stabilize and central banks in emerging markets ease monetary policy.”

“The next big move in emerging market equities will be dependent on how quickly the Chinese government eases economic policy,” added Hartnett.

A total of 186 fund managers participated in the global survey from September 5 to 11, managing a total of US$641 billion.

IE