A week of audacious attacks by militants - including a brazen assault on the main army headquarters - has killed more than 100 people and proven that Taliban militants and their allies are far from defeated.
'The Taliban attackers demonstrated that despite losing the campaign in the Swat Valley this summer, they retain the capacity for terror in the heart of Pakistan - striking, in effect, into the Pentagon of Pakistan, said Brookings fellow Bruce Riedel.
But that does not mean they are anywhere near winning a meaningful victory. Pakistan faces months or years of traumatic asymmetric warfare against militants who can create chronic insecurity but have no prospect of seizing control of the state.
However successful they may be in waging a destabilising guerrilla war, a few thousand tribesmen and militants cannot hope to defeat the world's sixth-largest military.
The growing risk that militant groups in the Punjab are making common cause with the Taliban to attack the state, as explicitly seen in the weekend's attack in Rawalpindi, is a concern but does not alter the fundamental military arithmetic.
A second key consideration is that outside tribal areas, the Taliban could never hope to win widespread popular support.
'We are not talking about a population that is radicalised en masse, by any stretch of the imagination,' said Control Risks analyst Claudine Fry. 'That is why we are not foreseeing state collapse or implosion. Most Pakistanis are moderate.'
This means there is little room for things to get much worse in Pakistan. The most likely negative scenario for markets is not that security worsens significantly, but that it stays the same.
Pakistan could remain locked in a stalemate for years, with the government distracted from policymaking and the country seen as a basket case by all but the most risk-hungry of investors.
The chaos that convulsed Iraq after the overthrow of Saddam Hussein in 2003 offers instructive parallels. Insurgents were highly successful at rendering areas of the country ungovernable, strangling economic growth and undermining policymaking.
Yet they never came close to creating the conditions for a takeover of power. Their campaign of violence had diminishing returns - individual attacks became increasingly irrelevant, and crucially, the civilian population became implacably alienated.
The long-term economic costs of Pakistan's chronic instability are high, but the damage has already been done. Markets will show little reaction to the conflict unless evidence emerges of a real shift in Pakistan's security profile. And because things are already so bad, most risks are on the upside.
The week's violence, particularly the embarrassment of the attack on the army's headquarters, may push the military to take a less ambivalent attitude and crack down hard on the Taliban.
'The Rawalpindi attack has sent shockwaves across the military leadership,' said Eurasia Group analyst Maria Kuusisto.
Over the summer, the army drove Taliban fighters out of Swat, and a US missile strike killed Taliban leader Baitullah Mehsud. The latest violence means a planned army offensive in the Taliban stronghold of South Waziristan is certain to be launched.
Support for strong action against the Taliban had been weakened by US goading. Many Pakistanis are incensed about the US Kerry-Lugar bill, which stipulates that to qualify for aid Pakistan must show commitment to fighting terrorism.
'Poll after poll shows Pakistanis increasingly do fear the threat posed by extremists... but they believe the US is an even bigger danger to their country,' Riedel said, adding many Pakistanis saw the US as a greater threat than India.
'And any time you outpoll India as the bad guy in Pakistan, you are in deep trouble.'
In this environment, there was limited enthusiasm in the army for a major crackdown on the Taliban. The Rawalpindi attack on army headquarters may have driven home to wavering military officers the importance of taking on the Taliban.
A sustained military crackdown that significantly undermined the ability of militants to launch attacks would give markets a long-term boost. But analysts say that while the conflict may ebb and flow, neither side is likely to strike a decisive blow.
Even if Taliban fighters are routed in South Waziristan, militants could launch attacks from other strongholds, including in the Punjab. This is why asymmetric warfare is so effective - even military defeats would not prevent small groups of determined militants launching repeated destabilising attacks.
So while there is little room for the situation to get any worse, few see any chance for now of things getting much better.
'The Taliban attackers demonstrated that despite losing the campaign in the Swat Valley this summer, they retain the capacity for terror in the heart of Pakistan - striking, in effect, into the Pentagon of Pakistan, said Brookings fellow Bruce Riedel.
But that does not mean they are anywhere near winning a meaningful victory. Pakistan faces months or years of traumatic asymmetric warfare against militants who can create chronic insecurity but have no prospect of seizing control of the state.
However successful they may be in waging a destabilising guerrilla war, a few thousand tribesmen and militants cannot hope to defeat the world's sixth-largest military.
The growing risk that militant groups in the Punjab are making common cause with the Taliban to attack the state, as explicitly seen in the weekend's attack in Rawalpindi, is a concern but does not alter the fundamental military arithmetic.
A second key consideration is that outside tribal areas, the Taliban could never hope to win widespread popular support.
'We are not talking about a population that is radicalised en masse, by any stretch of the imagination,' said Control Risks analyst Claudine Fry. 'That is why we are not foreseeing state collapse or implosion. Most Pakistanis are moderate.'
This means there is little room for things to get much worse in Pakistan. The most likely negative scenario for markets is not that security worsens significantly, but that it stays the same.
Pakistan could remain locked in a stalemate for years, with the government distracted from policymaking and the country seen as a basket case by all but the most risk-hungry of investors.
The chaos that convulsed Iraq after the overthrow of Saddam Hussein in 2003 offers instructive parallels. Insurgents were highly successful at rendering areas of the country ungovernable, strangling economic growth and undermining policymaking.
Yet they never came close to creating the conditions for a takeover of power. Their campaign of violence had diminishing returns - individual attacks became increasingly irrelevant, and crucially, the civilian population became implacably alienated.
The long-term economic costs of Pakistan's chronic instability are high, but the damage has already been done. Markets will show little reaction to the conflict unless evidence emerges of a real shift in Pakistan's security profile. And because things are already so bad, most risks are on the upside.
The week's violence, particularly the embarrassment of the attack on the army's headquarters, may push the military to take a less ambivalent attitude and crack down hard on the Taliban.
'The Rawalpindi attack has sent shockwaves across the military leadership,' said Eurasia Group analyst Maria Kuusisto.
Over the summer, the army drove Taliban fighters out of Swat, and a US missile strike killed Taliban leader Baitullah Mehsud. The latest violence means a planned army offensive in the Taliban stronghold of South Waziristan is certain to be launched.
Support for strong action against the Taliban had been weakened by US goading. Many Pakistanis are incensed about the US Kerry-Lugar bill, which stipulates that to qualify for aid Pakistan must show commitment to fighting terrorism.
'Poll after poll shows Pakistanis increasingly do fear the threat posed by extremists... but they believe the US is an even bigger danger to their country,' Riedel said, adding many Pakistanis saw the US as a greater threat than India.
'And any time you outpoll India as the bad guy in Pakistan, you are in deep trouble.'
In this environment, there was limited enthusiasm in the army for a major crackdown on the Taliban. The Rawalpindi attack on army headquarters may have driven home to wavering military officers the importance of taking on the Taliban.
A sustained military crackdown that significantly undermined the ability of militants to launch attacks would give markets a long-term boost. But analysts say that while the conflict may ebb and flow, neither side is likely to strike a decisive blow.
Even if Taliban fighters are routed in South Waziristan, militants could launch attacks from other strongholds, including in the Punjab. This is why asymmetric warfare is so effective - even military defeats would not prevent small groups of determined militants launching repeated destabilising attacks.
So while there is little room for the situation to get any worse, few see any chance for now of things getting much better.
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