For so many people, the world seems to be ending. Europe will collapse when Greece, Spain, Portugal or all three default and Germany will exit the Euro leading to tremendous global financial instability. Other dominoes will fall. Then, later on the US current account deficit will widen as a result, leading to a further, unsustainable global imbalances. As the Eurozone problems have no obvious solutions and markets are now forcing the issue, it is assumed that significant cyclical damage is yet to come.

At the same time, in China, the leadership appears to be mainly preoccupied with domestic issues, such as cracking down on perceived property market speculation. The measures have been forceful and frequent and there is no reason to think they will stop before the perceived aim of a “meaningful” correction in prices is achieved.

In the meantime, the media has focussed heavily on a factory strike at one of Honda’s component suppliers and a handful of suicides at an electronics assembly plant (Foxconn). Many companies subsequently increased wages by 30% or more. China’s manufacturing model appears to be under siege with recent very substantial increases in minimum wages. The newspapers have had a field day with this and everyone seems to think it’s “the end of an era”.

Of course China’s exports were going to be facing headwinds anyway from fiscal contraction in Europe and a jobless recovery in America. And while domestic consumption in China remains a bright spot, it is not perceived to be improving so rapidly that it can carry everything else. So, at the same time as Europe collapses into a heap of dust, China could soon see an economic hard landing.

The bearish view is widely perceived to be inevitable – as if the future had only one path. In many cases, markets have begun to price in a doomsday scenario. The cost of downside protection in the options market has skyrocketed – just look at 3 month skew for a variety of major market ETFs, including the US listed China ETF, FXI, etc… In some of these, skew now exceeds the very highest levels seen in 2008 or 2009.

The key question right now is, when will the high levels of fear seen in the market right now dissipate? Or, conversely, how easily could investors get more fearful from here? Markets have clearly already moved to discount these worries, so the big question is whether they have moved enough that forthcoming data can provide positive surprises. There are indications that we are nearly there or thereabouts.

While gauges of fear such as skew can always go higher, given their record levels, odds are that they have gone too far. It has also become increasingly clear that policymakers are now more concerned about “risks”. This was implicit at the recent G20 meeting held in Korea and can also be seen in Bernanke’s recent comments that he would not rule out a double-dip recession. Chinese officials continue to be deeply concerned about risks to the global economy. None of this leads us to believe that politicians will pull rabbits out of hats soon, but it does at least give us some comfort that a trigger point for more meaningful action is not far away.

While it is perhaps clearest in China that the concerns are overstated, this also appears to be the case for Europe and the global economy.

First, on China. So far, there are not too many indications that property measures have been impacting construction activity and fixed asset investment – but there is a significant lag, and this should be expected. Yes, the government wants to continue to increase supply, but as long as the incentive to speculate in property and invest in property is being stamped on, the incentive to build a lot of stuff won’t be there.

While credit default swaps on Chinese property companies imply a reasonably high chance of default sometime in the next 5 years, judging by Taiwan’s experience, this is highly unlikely to happen to more than one or two of the listed ones. The companies may very well end up as shadows of their former selves, but actual default by substantial listed Chinese property companies with net gearing of, say, 70%, is a possibility, but not the 50%+ probability that CDS markets seem to imply.

It is already clear that the property crackdown (among other things) has had an impact on equity markets – and to a lesser extent property markets. Property transactions are down sharply, and prices have also edged off. Transactions should lead prices, and as long as the property measures are not entirely reversed (and it would take fairly extreme circumstances to get policymakers to reverse them), we should see prices fall further. However, given how severely Chinese property stocks have underperformed the market, this should, to a large degree, be already priced in. We are almost at the point where rapid drops in property prices would be welcome news as a harbinger of looser policy.

Inflation is also near its peak. Base effects are likely to peak over the next few months. In the meantime food prices, a big inflation driver in China, have begun to tail off. So, while it is probably too early to say that inflation is not a worry in China, we expect a brighter future in the second half.

We think the market is heavily over-discounting the likelihood of contagion from Europe, property measures and labour cost rates and a sharp decline in the currency that are receiving too little focus. Amid the latest round of worries, policy rate expectations and longer-dated yields have largely fallen outside the most vulnerable economies too (US mortgage yields are at fresh lows). And the transmission from banking system problems to a broad funding crisis or the real economy – both inside Europe and beyond – is not as transparent as many assume.

When markets are skittish volatility increases and short term movements can clearly be very choppy. But incoming data has already begun to surprise on the upside – and this is the best reason for thinking that fears are likely to recede in the near future.

A brief read of the more recently released data looks good. Exports from China and Taiwan have already surprised on the upside – up 48% yoy in China in May versus 32% yoy in April, while in Taiwan they were even stronger – up 58% yoy in May versus 48% in April. Recent inflation numbers are benign, and in line with expectations (3.1% in China, 0.7% in Taiwan). Loan growth also slowed to a more sustainable, but still quite reasonable pace of RMB600bn. In China, property price growth has slowed, but there are no signs of an imminent nationwide collapse. From a Chinese policy perspective, it looks like everything is going in the right direction, and policy is currently on hold.

We expect most of the further data to support an outcome of “less bad than expected” which in the current context of very high risk aversion, will be enough to drive markets higher. Considerably higher than they are now by the end of the summer, we believe.

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