The sell-off on US markets illustrates fears that the $700bn bailout package will not avert recession, writes Arthur Beesley, on Wall Street

IN THE ground floor of the tower block overlooking the Hudson River where Merrill Lynch has its headquarters, there's a queue out the door at Starbucks before 6.30 most mornings. Whatever the time, the coffee shop is almost always busy.

But Starbucks itself is not immune to the turmoil that pushed Merrill into the arms of Bank of America last month. Omnipresent in the US, the company has closed outlets in the face of a sales slowdown. Now it wants to save money by employing fewer staff and having them work more hours.

Far off Wall Street, the financial crisis is extracting a heavy toll in the economy at large.

Hence the dramatic sell-off on US markets yesterday, which stands as a vivid illustration of investor fear that the Bush administration's $700 billion bailout package will not avert recession.

With the Californian state running out of money - and Florida, Nevada, Massachusetts and Ohio under pressure - the dire performance of the stock market is a painful reflection of stress and strain in the economy.

"Stocks are falling so fast because there is now a realisation that we're headed for some kind of very severe economic downturn globally and nobody truly has any idea how deep it will be," said Rod Smyth, chief investment strategist with Riverfront Investment Group in Richmond, Virginia.

"A fairly severe recession was priced into stocks 10 days ago . . . What has changed is that the short-term economic landscape has gone from being difficult but manageable to 'we don't know', and that's a classic environment of fear. I'm doing the work today that says now, at current levels, we're pricing in a very severe economic downturn already, all at once."

As the International Monetary Fund put it in a report last week, episodes of financial turmoil involving stress in commercial and investment banks "are more likely to be associated with severe and protracted economic downturns". With total losses in the global financial system now forecast to exceed $1.3 trillion, more than double the current tally, the resultant seizure in credit markets is making life tough even for strong companies.

This can be seen in the onerous investment terms Warren Buffett extracted from General Electric. An industrial giant that rarely demonstrates any weakness was willing to pay a 10 per cent annual dividend on preference shares in return for Buffett's support.

The strain is evident further afield, too. Anglo-Swiss mining group Xstrata last week backed away from a $10 billion deal to acquire platinum-maker Lonmin. Shaken by uncertainty in the credit markets, Xstrata pulled back from its offer because lending terms on offer weren't attractive enough. Like the mighty GE, Xstrata has a top-level credit rating.

Similar pressures are at work in big industry, where the seizure in credit markets and the evaporation of confidence means that even strongly profitable companies have to pay more money to raise cash for their operations.

Caterpillar, whose trucks and bulldozers are seen on building sites throughout the world, had to offer yields north of 6 per cent and 7 per cent when selling $1.3 billion in bonds at the end of September.

The company sold $300 million in bonds at a yield of 4.9 per cent a month previously. Jim Owens, its chief executive, was among a large number of senior business people that urged members of US Congress to endorse the bailout package.

Although finance directors in large organisations have many weapons in their armoury when recalibrating their fiscal strategy, the owners of some small companies have had to take drastic measures to their businesses on track.

"They're having more difficulty getting loans. The bank terms - interest rates and payment rates - are getting worse for our small businesses and they are being pushed into using credit cards because they charge a higher percentage interest rate and they're less tightly regulated than a traditional bank loan," says Molly Brogan of the National Small Business Association.

"Everybody is feeling the pinch and there's very low confidence in the US economy right now," she adds. Small but profitable companies that once enjoyed 60-day payment terms with larger suppliers have seen those terms decline to 30 or 15 days.

After the worst month for job losses in five years, current pressures point to continued retrenchment as the subprime bug spreads.