By By Jeremy Gaunt, European Investment Correspondent
The question for investors now is whether recent weakness on stock markets -- the MSCI all-country index fell for seven sessions in a row before rising on Friday -- reflects a return to last year's misery or is just a pause.
Adding to investor uncertainty, the troubles of the world banking system have risen to the fore again as the fourth-quarter earnings season gets underway.
U.S. President-elect Barack Obama will have a "strong message" for bankers once he becomes president on Tuesday, his senior adviser David Axelrod said on Sunday.
"We want to see credit flowing again. We don't want them to sit on any money that they get from taxpayers," Axelrod said.
The incoming Obama administration is considering setting up a government-run bank to acquire bad assets clogging the financial system, a person familiar with the Obama team's thinking said on Saturday.
Britain looks poised to guarantee "toxic debt" worth up to 200 billion pounds ($298 billion) in a second bank bailout designed to boost lending and fend off a prolonged recession, newspapers reported on Sunday.
British Prime Minister Gordon Brown said at the weekend that banks had to reveal the true scale of their bad assets to help revive global credit markets, as officials met to thrash out the new rescue package.
Albert Edwards, a veteran strategist at Societe Generale who is widely known for his gloomy prognostications, is clearly in a camp that expects big trouble ahead.
He told his clients at the end of last week to get out of equities, prepare for a 40 percent rout on the S&P 500 index <.SPX> and batten down the hatches for a depression.
"Economic data in developed economies increasingly reflects depression rather than a deep recession," he said.
Edwards has been almost unrelentingly bearish throughout the decade so the call was not out of character. But given that he urged his clients to buy stocks at the end of October, it did exemplify one market view that the end-of-year rally is over.
A more mainstream stance, however, is that global equities probably bottomed last November and that with various setbacks likely, they should gain this year with the investment cycle somewhat ahead of the global economic one.
"We are getting more positive," said Joost de Graaf, a senior portfolio manager at Kempen Capital Management in the Netherlands. "But the economy will certainly have a tough year in 2009 and the start of 2010."
Kempen increased its exposure to equities late last year and is considering doing it again, albeit cautiously.
As for the market itself, the rally took the MSCI index up almost 27 percent from a November 27 low, but it has since pared close to half of this back.
All this to be taken in the context of 43.5 percent nosedive last year, of course.
YES WE CAN
The biggest item of faith to which investors are clinging at the moment is that the huge intervention by governments into markets and economies will pull things together.
Barack Obama, who takes over the world's largest economy as U.S. president on Tuesday, is working with lawmakers to agree an $825 billion fiscal stimulus plan and has successfully lobbied for the second $350 billion of a financial rescue fund.
The Federal Reserve has taken interest rates down to a range of zero to 0.25 percent, the Bank of England is at 1.5 percent and the usually hawkish European Central Bank knocked 50 basis points off its rate last week to 2.0 percent.
"If you see the extreme fiscal stimulus and monetary easing ... the really big pain of a depression will be averted," de Graaf said.
There is a flip side to this, however, in that the amount of government intervention in fiscal and economic matters across the world is so unprecedented that investors are not sure what impact it will have or where it will be directed next.
As a result they have become more cautious, with some putting off major investment decisions until a clearer picture emerges.
"The extraordinary steps taken by central banks to ease liquidity conditions and get the credit markets functioning are finally working," State Street said in its latest note on investment flows.
"Earlier in the crisis this good news would have been seized upon by institutional investors. But the damage to the real economy has already been done. That is why sentiment remains poor and investors are still sitting on the sidelines, happy to eschew equities with what is likely to be a brutal earnings season just getting started."
OLD RISKS AND NEW
Set against this climate, investors have also been gripped by the return of an old concern -- the state of world banks.
Citigroup
Shares in Europe's biggest bank, HSBC <0005.HK>
Deutsche Bank
Ireland stepped in to nationalize Anglo Irish Bank.
It was the suffering of global financial institutions, including the collapse of Lehman Brothers, that really pulled the plug on investments in riskier assets last year, sinking equities and boosting bonds.
This week will bring a wave of fourth-quarter U.S. bank earnings that should keep markets on their toes.
The biggest threat to market and economic recovery, however, may be found in China. Investors are increasingly concerned that a hard landing there could undermine all that the rest of the world has been doing to stem economic turmoil.
Societe Generale's Edwards, for example, reckons China's economy is already imploding, threatening a trade war that could lead to a global depression.
Risk analysts working with the World Economic Forum listed a sharp decline in Chinese growth as one of the most significant and increasingly likely threats to the global economy.
It all suggests more caution and potential volatility on financial markets in the weeks ahead.
(Editing by Richard Hubbard)
