With fears of a renewed financial crisis in Europe once again on the rise, it looks like the region may suffer a deeper-than-expected recession, which crimps the outlook for Canada, too, suggests National Bank Financial (NBF).

In a new report, NBF notes that the rising probability of a Greek exit from the euro, and a weakening of the European financial system, is driving resurgent fears of a financial crisis. The economic picture isn’t looking much better, NBF adds.

While several European countries avoided a second consecutive quarter of contraction in Q1 of 2012, NBF says that indicators for both manufacturing and services point to a deterioration in the second quarter.

At the same time, China is seeing clear signs of a cooling in its domestic demand, which will weigh on global growth, and particularly resource sectors, it notes.

“Current developments suggest that the balance of risk has moved toward a worse-than-expected recession in Europe and increased stress on the European financial system implying the possibility of a higher-than-expected risk premium for equities, and a contraction of P/E multiples that would compromise price targets,” it says.

Indeed, while the firm isn’t lowering its current year end target of 12,720 for the S&P/TSX Composite Index, it says it’s now at the high end of its comfort zone.

The report notes that the Canadian equity market has been under pressure since late in the first quarter, “partly because of price weakness in key commodities including crude oil, copper and gold”. And, it notes that small caps have been particularly hard hit, with the S&P/TSX Composite down about 21% from its 2011 high, and the S&P/TSX Venture Index down 50% from its peak of early 2011.

“With equity markets expected to remain volatile over the coming months, the underperformance of small caps is likely to persist,” it says.

On the earnings front, NBF says that over 90% of the companies in the S&P/TSX Composite have now reported their Q1 earnings, producing single digit growth in both earning and sales. In general, top-line growth is well below expectations, it says, with only 45% of companies beating estimates.

“Soft top lines are largely the reason for severe downward earnings revisions in the Canadian equity universe since mid-2011,” it says. “Unless earnings expectations stabilize, Canadian equity prices will not easily gain traction in the coming months.”

The U.S. market fundamentals look a bit more positive, NBF says, although the earnings backdrop is weakening there too. Nevertheless, it is currently slightly overweight U.S. equities, underweight Canadian and foreign equities, and overweight both cash and Canadian bonds.

The medium-term outlook for the market depends on Europe and China, it says. “The biggest risk to the Canadian market is the possibility that a stronger-than-expected correction in commodity prices will dictate further downward revision of our earnings outlook,” it says.

In the meantime, it’s expecting U.S. stocks to “provide some shelter through currency appreciation”, and has a year-end target for the S&P 500 of 1385. “We also continue to recommend a large cash holding in this period of elevated risk,” it adds.