Markets braced for falls after US scare

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Investors were this morning steeling themselves for major reversals on the London stock market amid heightened fears of a global economic slowdown.

Traders have endured a nervous weekend following the Dow Jones Index's 367-point fall on Friday afternoon, which came as US investors were panicked into dumping stock by warnings of an impending recession in the US.

The US stock market decline – the Dow Jones closed 2.6 per cent down on the day on Friday evening – was triggered by a warning from the industrial giant Caterpillar that many of its markets were already in "recession". Caterpillar, widely seen as a bellwether for global industry, said the US economy as a whole would also move into recession next year unless the Federal Reserve moved quickly to cut interest rates.

Western stock markets, including the UK, have so far ridden out fears that the global credit crisis may have far-reaching economic consequences, but Friday's reversals in the US are likely to be repeated elsewhere amid speculation that the impact of the crisis may be worse than expected.

"Fear has definitely come back," said one analyst. "You can feel it. People are worried about the unknown in the financial stocks."

Frederic Dickson, chief market strategist at the investment manager DA Davidson & Co, described Friday's setback on Wall Street as a "market explosion", adding: "There's going to be a lot of pain."

The change of sentiment on global stock markets, though sparked by Caterpillar's explicit use of the word "recession", follows a series of warnings that buoyant stock market valuations may now be out of sync with the underlying economic fundamentals. In addition to a housing crisis, the US – which accounts for half the world economy – is feeling the effects of soaring oil prices and a collapse in the value of the dollar.

In the UK, strong corporate profitability has pushed the FTSE 100 Index to levels not seen for seven years in recent weeks, with the market at one stage less than 200 points short of the all-time high recorded at the end of the boom in the late Nineties.

However, last week, the International Monetary Fund trimmed its forecasts for global economic growth in 2008, warning that the crisis in credit markets was likely to restrict the ability of businesses to expand.

In the UK, the Chancellor, Alistair Darling, has also warned of slower-than-expected expansion, reducing the Government's forecasts for economic growth next year in this month's pre-Budget report.

In this context, Josef Ackermann, the chairman of Deutsche Bank, yesterday said it was "somewhat astonishing" that share markets, despite Friday's falls, have been doing so well.

All these fears are likely to be compounded by today's autumn bulletin from the influential Ernst & Young ITEM Club. It will say that it now expects the UK's economy to grow by 2.1 per cent during 2008, down from its July forecast of 2.5 per cent.

Professor Peter Spencer, chief economic adviser to the ITEM Club, said he did not believe that the UK itself was at risk of recession, or that there was any prospect of a housing market crash, but he warned of a period of belt-tightening.

"Growth is set to slow next year as a result of the marked tightening of monetary and credit conditions seen over the summer," Professor Spencer said, adding that the slowdown would leave the Treasury with little room for manoeuvre. "Weaker tax receipts from the City will have significant consequences for the Chancellor, boxed in as he is on very tight revenue, borrowing and spending plans."

Stock market investors may also be spooked by the unfortunate timing of Friday's setbacks in the US, which happened 20 years to the day after Black Monday, the stock market crash that wiped more than 11 per cent off share prices in October 2007.