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Negative sentiment currently dominates the equity markets. Retail investors are exiting equity markets throughout Europe and the world as the credit crunch continues to destabilise the financial system. Such investors have seen a ferocious bear pursuing them, and their running is an instinctive and understandable response.

However, for those with the means and mettle to stick around, a new, but promising, landscape is taking shape.

Mass capitulation creates very real investment opportunities. Many of the investment greats made careers out of differentiating between superior and inferior assets. Their best returns came from buying quality stocks at very low valuations, usually when fear and panic ruled.

With European markets having fallen by more than 40 per cent from their peak, according to Bloomberg, they now yield more than 5 per cent, excluding financials. With German government bond yields having dropped below 4 per cent, equity markets are scarcely wildly overvalued, and value is emerging in the aftermath of the bear rampage.

The recent months have seen the credit crisis move to centre stage. Although headline inflation rates remain elevated, markets have turned their attention from concerns about commodity-driven price rises to the possibility of Japanese-style deflation as assets are liquidated and economic growth slows.

The ‘credit bubble’ has been a preoccupation for several years. The current crisis is the inevitable final phase in what has been a giant experiment in leverage, carried out in the financial system without the regulators apparently noticing.

Paradoxically, the damage wreaked on the world’s financial markets in recent weeks (including the demise of Lehman, AIG, HBoS, WaMu and Merrill Lynch) has dispelled any residual denial about the seriousness of the crisis.

The move by the US authorities towards a more systematic rescue plan, as well as the fact that financial failures in the UK and Europe are no longer being seen as ‘one-off’ events, bodes well for a more coordinated global approach to the crisis. This will ultimately lead to the authorities underwriting large parts of the financial architecture in order to restore confidence. Competition rules are already being flouted as in the case of the Lloyds TSB/HBoS deal and Ireland guaranteeing all deposits in its banking system.

Questions about moral hazard and retribution will inevitably arise, but these will have to wait. In the short term this is about firefighting, and administrations will do anything in their power to stabilise the situation.

That the state needs to get involved is clearly bad news for capitalism in the longer term, but a ‘market’ or entirely private-sector solution is clearly out of the question given the low level of confidence in banking systems that are undercapitalised and have balance sheets the size of countries. In the UK, for example, the top-four lenders have gross assets estimated at £6.5trn, or approximately 400 per cent of GDP.

It is important not to confuse measures to stabilise the financial system with those that would bail out banks’ management or shareholders. Stabilisation is a precursor to recapitalisation; banks need to raise fresh capital and cut dividends. At the very least, bank shareholders are likely to experience significant dilution and, in the longer term, regulation will be intense and include caps on leverage, which will severely limit profitability.

What seems clear, then, is that deleveraging in the financial sector will continue. Authorities’ interventions should, in time, improve the availability and cost of credit but a return to the good old days of cheap and plentiful credit is not likely any time soon. Bank deleveraging will be reflected in the economy as a whole, putting pressure on capital spending and - most importantly, for economies like the UK and US - on consumption and asset prices for the foreseeable future.

Objectively, one might expect a financial crisis of generational proportions to result in a global recession on a similar scale. Here, however, there may be grounds for guarded optimism. Though the more highly leveraged consumer- and real estate-led economies (such as the UK, US, Spain and Ireland) will undoubtedly experience recessions, how much the world economy slows in aggregate depends on a number of factors.

The first of these is how aggressive and imaginative the policy response proves to be in the economies at the heart of the crisis. The second is the resilience of economic activity in less leveraged economies, such as those in core Europe and Asia. The last is the ability of the developing world both to stimulate its economies, for which there is ample firepower, and to shift the emphasis of its still relatively robust economic growth towards domestic consumption. The good news is that authorities worldwide are now all likely to take action; interest rate cuts and a raft of stimulating policies are likely to follow.

Although there is a medium-term road map, as described above, the short-term volatility in all capital markets makes running portfolios containing any risk assets extremely difficult. Bear markets and financial panics are characterised by periods of extreme volatility and intense intra-market rotation.

It has been wise to advocate caution in constructing portfolios for several years, and now would not seem to be the time to change that view. As indicated above, the outlook is not pretty and market-based capitalism faces considerable challenges.

Capital markets will survive, however, albeit in an altered and more highly regulated form. The credit markets are currently in the process of repricing, and future investors therefore will be more adequately rewarded for risk. This is already opening up opportunities and more will follow.

In Europe, domestic demand has clearly been pressured by high food and fuel price inflation and rising interest rates. Falling food and fuel prices will boost real disposable income, releasing the European Central Bank from its duty to fight inflation first and foremost. Further interest rate cuts are therefore likely going forward. These factors would be a powerful offset to the negative news stemming from the credit scarcity and deleveraging.

Weaker growth and lower rates are likely to lead to euro weakness against the dollar. This is necessary for European export growth to resume in 2009. Earnings expectations are becoming more realistic in most parts of the market. The only exception is in the industrials sector, but even here the weak performance in the third quarter suggests that the market is now expecting downgrades in the coming months.

European equity market valuations look attractive from a historical basis and compared with bonds. Of course, much still depends on the severity and duration of the slowdown. However, thorough, careful stockpicking within and across sectors offers more scope to add value than for many years. The best equity policy continues to be highly selective.

Carefully chosen equities can continue to provide superior returns for the longer-term investor, albeit with lower returns than those to which we grew accustomed in the two decades preceding the turn of the century and with volatility closer to long-term averages.

Raj Shant is director of investment management, European equities, at Newton Investment Management, a subsidiary of BNY Mellon Asset Management