Jitters about the U.S. economy and the credit crisis kept investors away from riskier assets on Tuesday, sending stocks sharply lower and boosting the Japanese yen against higher-yielding currencies.

Wall Street looked set to open lower.

Caution grew on the back of Monday's data showing growth in U.S. factory activity slipped in November to the lowest since January and after Federal Reserve policy makers gave a sober assessment of the world's biggest economy.

Investors have also settled into a pattern of blowing hot and cold with sentiment, lifted by hopes for further interest rate cuts and depressed by poor data and a continuing drip of fear about the credit market.

Brokers Punk Ziegel downgraded Bear Stearns, Goldman Sachs and Lehman Brothers to sell from market perform, saying the retrenchment under way will force significant adjustments in the way the businesses are being run.

This led to expectations of more angst on Wall Street.

The question no one can answer is how much garbage paper is on the books of these big firms. Right now I don't know if they're sitting on a dollar of junk or a billion, said Barry Ritholtz, director of equity research at Fusion IQ in New York.

MSCI's main world stock index was down 0.3 percent on the day, held up from deeper losses by its emerging market components. Emerging markets were bucking the general downward trend with a 0.1 percent gain.

European shares fell, led lower by handset maker Nokia and steelmaker ThyssenKrupp, whose updates left investors unimpressed.

The FTSEurofirst 300 index of top European shares was down 1.4 percent.

It's difficult to see a year-end rally, with the headwinds so strong: oil, the financial crisis, and housing markets, said Franz Wenzel, a strategist at AXA Investment Managers in Paris.

Focus was also on interest rates with European Central Bank seen holding and some betting on a Bank of England cut on Thursday. The Fed is widely expected to cut next week.

Earlier, economy-sensitive machinery and shipping shares dragged Japanese stocks lower. The benchmark Nikkei closed down 0.95 percent to 15,480.19, down 148.78. The broader TOPIX finished down 1.09 percent at 1,515.50.

DOLLAR, BONDS

The yen gained against the dollar and higher-yielding currencies as concerns about credit turmoil and escalating tensions in the money market prompted investors to cut back risky positions.

The dollar also lost against the euro as investors awaited this week's key U.S. employment report and the Fed's meeting next week.

The focus is on the perception of risk and how quickly the U.S. economy is slowing, said Jeremy Stretch, market strategist at Rabobank. The financial stress is continuing to build.

The dollar was down 0.7 percent at 109.65 yen while the euro was down 0.3 percent at 161.61 yen.

The euro was up 0.5 percent at $1.4736.

Yields on 10-year paper were at 4.04 percent, while the two-year cash yield was at 3.77 percent.

Data from investment bank Citi showed that some sectors of government bonds are easily outperforming equities this year thanks to risk aversion triggered by the credit crisis.