Former army chief and firm US ally Musharraf resigned last week as president to avoid impeachment and markets initially rose briefly as investors hoped the government would finally pay attention to the sickly economy.
But persistent squabbling among coalition leaders led to the break up of the alliance on Monday. Some investors said the political uncertainty would keep them away even though some Pakistani stocks looked cheap, and the rupee was undervalued.
Pakistan's stock market is at a new two-year low and the rupee has weakened to a new record low.
"We see value, but we are not going to go fully invested with this amount of political uncertainty," said David Graham from Dalton Strategic Partnership, which manages $2 billion globally.
Graham said he hoped the government would firm up its policies after legislators elect a new president on Sept. 6.
Musharraf, who came to power in a 1999 coup, has always been credited for his business-friendly rule. He developed Pakistan's capital markets and privatised businesses.
More importantly, he turned Pakistan into a strong US ally in the war on terror, which helped Pakistan secure more than $11 billion of US aid -- a key support for Pakistan which has had a trade gap every year in the last eight fiscal years.
Analysts said the coalition government has so far showed it will continue Musharraf's policy of military action against militants, and securing the border with Afghanistan.
"The departure of Musharraf does not necessarily mean that stability and a guarantee of U.S. aid is out the window," said Mark Mobius, executive chairman at Templeton Asset Management. Mobius said Pakistan's stock market has "probably already discounted the worst case scenario". The Karachi Stock Exchange index trades at 6.2 times its 2009 earnings, compared with 7.2 times for the key Turkey stock index XU100, which was also hit by political tension this year.
Mohammad Fawad Khan, an analyst at Merrill Lynch, said Pakistan's net outflow of portfolio funds this year is expected to exceed last year's $212 million. To be fair, analysts said the six consecutive years of healthy economic growth in Pakistan under Musharraf's rule were aided by buoyant capital markets and economies worldwide. Similarly, the coalition government cannot take all the blame for runaway inflation, and trade and fiscal deficits which have widened alarmingly due to high oil and food prices.