Confidence. It’s the number one driver of business. Without it, business managers tend to hold off on new investments, keep inventories lean, and hold on to cash. That’s what happened in the United States in 2008, as sinking confidence led to a vicious circle whereby more and more companies shed workers and slashed orders, because their key customers had done so.

Could a similar spiral play out in Europe? It’s too early to tell. Much will depend on how banks react in this current environment. If they cut off lending to small and medium-sized businesses, as happened here roughly 18 months ago, then that could trigger yet another recession on the Continent.
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That’s why it is so important to track the actions of leading European banks. We already know that major banks in Ireland and Spain have begun to retrench, which bodes ill for the economies of those countries. But what about the likes of Deutsche Bank (NYSE: DB), UBS (NYSE: UBS) and Barclay’s (NYSE: BCS)? Those leading financial institutions’ actions will determine whether credit flows or shrinks.

France’s Credit Agricole is a clear example. The bank recently announced that it has more than three billion Euros at risk related to Greece. If half of that loan exposure ended up in default, Credit Agricole could weather the hit, and still keep lending. Then again, if loan troubles emerge from its exposure to countries like Spain, Portugal and Ireland, then Credit Agricole could be forced to call in loans from its otherwise healthy French customers. Germany stands alone, thanks to its massive export machine, as the one country that can muddle through if the rest of the Continent sinks into recession. But even there, GDP forecasts would need to be pinched.

For many, the International Monetary Fund’s decision to provide support to the banking system implies that credit will keep flowing. But as we saw with the United States’ Troubled Asset Relief Program (TARP), just because banks have access to capital doesn’t mean they will lend.

Moreover, as countries start to tackle their ballooning budget deficits, they will need to find ways to boost taxes and cut spending. And that can create a real drag on economic growth. Many argue that U.S. budget deficits of the last decade acted as a source of capital for the eventual housing bubble, as the government spent more and taxed less.

The broader point here is that it’s simply too risky to start looking for stock market bargains in Europe. Stocks are not yet cheap enough to account for the potential risk. Consider the Vanguard European ETF (NYSE: VGK), an exchange-traded fund (ETF) that seeks to track the performance of an index that measures the returns of stocks in major European markets. VGK reached a multi-year high of about $80 in 2007, and bottomed at around $30 during the recent economic crisis. Shares peaked at around $50 this past winter and spring, and were back down to just under $42 at Thursday’s close.

The Silver Lining

Yet investors also have reason for hope. That’s because Greece’s economic woes highlight the imprudent nature of too much government regulation and a too-large welfare state (and I write this as a supporter of good regulation and a sound social safety net). Greece is in the process of making painful cuts in benefits that will eventually create a far more competitive environment for businesses.

And once that happens, European economies may finally break from their low-growth/no-growth results from recent decades. You need simply to look at the United States in the 1990s. In the early part of the decade, many companies slashed payrolls at the same time that the government started paying off the national debt. That eventually led to a profit explosion and a hiring boom later in the decade. Europe, with its massive well-educated workforce and impressive transportation and trade infrastructure, will eventually prove to be a very appealing market.

Action to Take –> The euro’s recent sharp depreciation will start to impact many companies’ results in the current quarter. U.S. multinationals that derive a large chunk of sales from Europe will take a double hit: European profits that are converted into U.S. dollars will be some -10% to -20% lower than previously planned. And those companies are likely to see increased competition from European firms that are benefiting from a de facto -10% to -20% cut in costs. Multinationals that focus on the consumer sector, such as Procter & Gamble (NYSE: PG), or heavy equipment makers like Caterpillar (NYSE: CAT) will likely feel a direct hit to profits. At last check, the consensus earnings forecasts for these kinds of companies have yet to come down.

However, European firms that are export-focused look fairly appealing, thanks to the newly-competitive euro. That’s why shares of firms like BMW and Daimler are still trading well in their respective home markets. 

As noted earlier, the Vanguard European exchange-traded fund fetches half of what it was worth three years ago. If European economies can successfully restructure their spending levels and debt burdens, then the ETF could double or even triple form current levels over the next five years. But right now, we haven’t yet seen the political will to embark on a far-reaching economic restructuring.