The market's dark days aren't over yet

It's been a historic week for markets as investors finally caught a glimpse of just how bad things really are. And there are plenty more scary scenarios ahead that should curtail any revival.

It's been a historic week for stock­markets. "I can't remember a day like this", one dealer told the FT on Monday. While US markets were closed for a public holiday, their global counterparts plunged.

Over £77bn was wiped off the FTSE 100 as the index slid by 5.5%, the worst one-day loss since 11 September 2001. Germany and France fell by 7.2% and 6.8% respectively. On Tuesday Asia kept sliding; Hong Kong saw its worst two-day fall since the Asian crisis. The MSCI Asia-Pacific index, having slid by more than 20% since its peak in October, has followed Europe into an official bear market.

And just before Wall Street opened on Tuesday, the Federal Reserve slashed US rates by 0.75% a week before its scheduled meeting, the biggest cut in 20 years. The measure, which smacked of panic, received a mixed reaction: UK and European markets finished Tuesday in the black, but Wall Street remained down.

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Chalk up the plunge to a "Wile E. Coyote moment", as Tom Stevenson says in The Daily Telegraph the cartoon character "runs off the edge of the cliff, looks down and realises there's nothing there". Investors are finally looking down and seeing how bad things really are. They are realising that the US is in, or nearly in, recession and that the credit crunch is set to dampen growth as banks remain cautious on lending.

Financial sector woes look likely to be "deeper, and last longer, than previously thought", says Gillian Tett in the FT. The banking sector slump will continue through 2008 and 2009, says ratings agency Standard & Poor's, while more bank write-offs are on the cards. Analysts have now warned that Chinese banks are likely to take unexpectedly large write-downs on subprime-related securities.

Investors also seem to be losing faith in the decoupling thesis. The IMF's Dominique Strauss-Kahn says "the situation is serious all countries are suffering" from the slowing US. Singapore's surprisingly weak recent export and GDP data suggest Asia can't escape America's influence, while domestic consumption in Asia's export-led economies is insufficient to offset a US slump. Moreover, says Adrian Mowat of JPMorgan, Asian stockmarkets remain "pretty highly correlated with the US in terms of corrections".

And President Bush's fiscal stimulus plan, worth around $150bn, or 1% of GDP, looks like too little, too late, says Lex in the FT. It includes a series of measures to give people cash, including tax rebates. But according to Merrill Lynch, falling house prices are slashing consumer wealth, with $360bn set to be wiped off consumer spending in 2008 and 2009 more than double the proposed sum.

And what of rate cuts? In 2001, they inflated the housing bubble, but now that it has burst, consumers are mired in debt and household balance sheets are under pressure, curtailing spending. "This is not a great time to take on debts, but to pay them off," as Wolfgang Munchau says in the FT.

With America out of bubbles and banks tightening credit, rate cuts are unlikely to give the economy or markets a significant boost as the housing and credit bubbles unwind. Post-bubble deleveraging tends to play out despite the Fed's best efforts, says Merrill Lynch economist David Rosenberg.

On the credit front, there is a crisis of confidence in US monoline insurers. These provide guarantees to lesser-quality bonds with a value of $2.4trn, effectively lending their AAA-credit rating to the weaker firm in return for a fee. Until recently, they concentrated on municipal bonds but have now gone into mortgage-backed security markets to boost earnings. Due to the subprime mess, this is hurting their business and balance sheets and threatening their credit ratings.

If they lose their triple-A ratings, the bonds they insure will too, falling in value and causing a fire sale as those investors restricted to the safest bonds are forced to sell. It would also trigger fresh losses at investment banks, "which thought they had hedged away some of the risks on their subprime portfolios", says The Guardian's Nils Pratley.

Last week, concern over the two biggest insurers, MBIA and Ambac Financial, mounted. Ratings agency Fitch cut Ambac to AA and S&P looks likely to follow suit, in effect crippling the group, says James Quinn in The Daily Telegraph. Last week the market saw a 70% chance of both going broke, judging by what it was charging MBIA to insure recently issued debt designed to shore up its balance sheet. "If one of these entities doesn't make it the secondary effect could be pretty terrible," says JP Morgan chief executive Jamie Dimon.

There's also scope for earnings disappoint­ments. Analysts still expect US profit growth of 16.1% in 2008, while earnings-per-share growth of 11% is pencilled in for Europe, where over 80% of firms are expected to grow margins. Yet real earnings are already 83% above trend, says Morgan Stanley. Peak-to-trough earnings drop by a third in a typical cycle, says Lex; given historically high profitability, this isn't a typical cycle, so there may be a bigger drop ahead. With energy, industrial and financial stocks battered, investors are rightly starting to ponder "scary scenarios".