World stocks fell by more than 1 percent on Monday, led by sharp drops in Asia, while government bonds and the dollar rose as doubts about the strength of a global economic recovery triggered a risk asset sell-off.

The benchmark MSCI world equity index headed for its biggest one-day loss since early July. Chinese stocks <.SSEC> hit a two-month low and posted their biggest daily drop in 9 months, having rallied more than 85 percent since January.

Friday's data showing a further deterioration in U.S. consumer confidence overwhelmed a report on Monday that Japan became the third G7 country after Germany and France to pull out of recession.

There is now a realization that coming out of a recession is one thing, but building a recovery is another, said Justin Urquhart Stewart, director at Seven Investment Management.

We are now down to how companies are going to grow. The growth we have seen out of Japan as well as Europe looks like it has been primarily based on government stimulation ... The question is, is this sustainable? MSCI world equity index was down 1.4 percent. The FTSEurofirst 300 index <.FTEU3> lost 1.1 percent.

Shanghai stocks <.SSEC> fell 5.8 percent to their lowest close in two months on worries about added share supplies and commodity price declines. The index is down more than 17 percent from its 14-month high hit a fortnight ago.

According to Thomson Reuters data, the price to earnings ratio -- a valuations measure -- on Shanghai stocks has nearly doubled to 28 times since the start of the year following the rally. This compares with the P/E ratio of 15.7 times on the S&P 500 index <.SPX>.

Emerging stocks <.MSCIEF> fell 2.8 percent. U.S. stock futures were down around 1.4 percent, pointing to a weaker open on Wall Street later.

U.S. crude oil fell 1.8 percent to a two-week low of $66.29 a barrel.

The September bund futures rose 17 ticks to a two-week high. In Britain, the yield on two-year gilt hit a new all-time low of 0.855 percent as prices surged.

The dollar <.DXY> rose 0.3 percent against a basket of major currencies while the yen was 0.1 percent firmer at 94.68 per dollar.

A creeping rise in risk aversion could provide the dollar with a temporary boost, Citi said in a note to clients.

A more decisive market correction could be triggered by a resumption of flows into the market and/or evidence that China lacks control over its overheating economy and its frothy financial markets. We expect the yen to remain well bid in this context.

(Additional reporting by Joanne Frearson; editing by David Stamp)

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