The latest version of Merrill Lynch’s Survey of Fund Managers finds institutional investors in their gloomiest mood ever recorded in the survey.

The survey, completed as global equity markets fell by 18.7%, shows that 69% of respondents believe that the global economy has entered recession, up sharply from 44% one month ago. The proportion of investors who believe that monetary policy is too restrictive has reached 59%, representing a new high for the survey.

It also found that growing risk aversion has led to a record 49% of respondents to overweight cash. However, the number of respondents who believe equities are undervalued has reached a 10-year high, at 43%.

“Fund managers are waiting for the triggers that will give them the confidence to buy,” said Gary Baker, head of EMEA equity strategy at Merrill Lynch. “What they are looking for is a loosening of monetary conditions and for third quarter earnings to clarify where problems and opportunities lie across equity markets.”

Third quarter earnings season will be a vital input to investors’ portfolio decision making and to gauging how the financial crisis has impacted the real economy, Merrill suggested. Respondents appear to be placing little or no credibility in consensus earnings estimates for the year ahead, it observed, as 92% of respondents regard estimates as “too high,” and more than half say estimates are “far too high”.

Investors are gloomiest on Europe, as 41% of global asset allocators are underweight euro zone equities. Europe has now assumed the U.K.’s mantel as the world’s least popular destination for equity investment, Merrill said.

Within Europe, a record 90% of respondents expect economic conditions to worsen, while the percentage of European specialists forecasting recession has doubled to 74% from 37% in September. The outlook for corporate earnings can hardly worsen, Merrill said, given that 97% believe EPS growth will be weaker in the 12 months ahead.

“Against this backdrop of fear over profits and recession, investors are selling expensive, highly cyclical industrials and opting instead for stable dividends and capital preservation,” said Karen Olney, lead European equities strategist at Merrill Lynch. Investors have stampeded out of Industrial Goods & Services over the past month, with 49% underweight the sector compared with 8% in September.

The biggest overweight positions are in Telecoms and Healthcare, which traditionally provide safety and income. European sector allocation shifts over the past month suggest that investors have been moving towards remain pockets of potential growth that are less exposed to the credit crisis, such as Media and Technology.

The survey also found U.S. fund managers are now much closer to fully accepting what they expect will be a deep and prolonged U.S. recession. “In our view, however, it is too soon to say we have reached a bottom in equity markets given the current financial market turmoil,” said Sheryl King, senior U.S. economist at Merrill Lynch.

Financial rescue measures announced by governments in Europe and the U.K. to address bank security and liquidity will be positive, but will fundamentally alter the way bond investors approach banks, the firm noted. “Banks are now in a position to refinance 250 billion euros of maturing debt, a relief for credit investors. However investors will need to be aware that the plans are set to create a new super senior tier of bank debt. Any new state-backed debt will outrank existing debt in the bank’s capital structure,” it said.

“The subordination of existing debt is a small price to pay for this rescue,” said Richard Thomas, head of EMEA bank credit research. “More importantly, investors will see banks as an adjunct of the public sector — not just in terms of state ownership and debt guarantees but also as their lending activities take on an element of public policy.”

A total of 172 fund managers participated in the global survey from Oct. 3 to 9, managing a total of US$531 billion.

IE