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.
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 (
? 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
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 (
), just because banks have access to capital doesn't mean they will
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 (
, an exchange-traded fund (
) 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
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
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 (
, or heavy equipment makers like
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
-- David Sterman
Disclosure: David Sterman does not own shares of any security
mentioned in this article.
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