Economists are starting to foresee a more painful recession in the U.S., taking earnings estimates and stock market forecasts down as well.

National Bank Financial Ltd. declares in a report published on Thursday that “the recent developments in the U.S. have led us to rescale our economic outlook. Our scenario has shifted from a mild U.S. recession to a more serious one.”

That stance is echoed in a research note out on Thursday from Morgan Stanley. It warns that two “adverse feedback loops” threaten to turn the mild recession it expects into a severe recession.

“One involves spreading weakness beyond housing to consumer and capital spending, and from a global slowdown to U.S. exports, which will promote further declines in employment, in turn pressuring income, consumers and their lenders. A second vicious circle runs from tighter credit to a weaker economy and to a deterioration in credit quality, in turn increasing reluctance to lend,” Morgan explains. “Both threaten an economy now on the brink.”

As a result of its dimming forecast, NBF has also lowered its earnings outlook. It reports that S&P 500 earnings typically sag by 16% on average around recession periods. In Canada, pressures on profits usually last longer, it adds, noting that S&P/TSX earnings usually decline by 36% over a period of 26 months around recession periods.

“However, we expect these lower earnings expectations to be partially offset by a multiple expansion stemming from an upcoming accommodative monetary policy,” it notes.

Indeed, Morgan Stanley argues that policy responses designed to break the two feedback loops are critical for judging how deep and how long the current downturn will be. It says that the proposed U.S. bailout would likely mitigate the credit crunch, “but its future is uncertain.” The other major card that policymakers have is rate cuts.

“Two weeks ago, Fed officials left monetary policy on hold and stated that they saw a balance between the upside risks to inflation and downside risks to growth. That was then,” Morgan Stanley says. Now, global money markets are frozen “and incoming economic data portray a rapidly darkening outlook for U.S. housing, consumer and capital spending and growth abroad.”

“Thus, the unfolding dynamics of frozen U.S. financial markets and what could be a serious economic downturn may force Fed officials to ease monetary policy soon,” it says. But it also suggests that the Fed may be wary of taking unilateral actions that appear to respond to market developments: “As the credit crunch and the economic slowdown have gone global, such a move would have more impact if coordinated with other central banks.”

Nevertheless, given the gloomier economic outlook and strong headwinds expected in commodity prices, NBF has also reduced its S&P/TSX target from 12,800 to 12,200.

“Looking ahead, it is important to remember that equities always bounce back before the economy does and that their rebounds are steep. In past recessions, the S&P 500 recouped an average 30.18% within six months of the market trough. Even if this financial crisis maintains credit conditions tight for some time and is accompanied by a subpar economic recovery, we remain confident that equities will ultimately rebound many months before profits do,” NBF adds.

The firm has also started to overweight financials after three years of being on the sidelines. “In our opinion, our banks are better capitalized and much less leveraged than their foreign counterparts,” it says. “As for the resource sector, we remain underweight and believe it is still too early to reconsider it (despite the huge equity price correction), as the global economy is poised to decelerate even more in 2009 and the U.S. dollar bottoms out.”