Geopolitical Developments: Europe Is Being Dragged Down Despite Hedging Their Participation In Putin’s War

Putin’s attack on the global order may end shortly if his inner circle echo the pessimism and discomfort Russian Foreign Minister Lavrov evidenced yesterday, but there is no concrete indication of that yet. And with each horrifying day the crisis extends the deeper Europe slides into an economic hole. The volatility risk premium points to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), but my technical reading of key stocks in the S&P 500 is bearish. There are several negative factors across global asset classes. The action in currencies signifies $US strength. The US yield curve is bear flattening. Expect the S&P 500 to fall over the next few days.

A key financial development from the Ukraine crisis is the incipient retrenchment of European banks. This is due to their considerable exposure to Russia, which means the coming writeoffs will not only force them to write down some of their capital, but more importantly impact their future capital. European banks make money in Russia due both to interest rate differentials but also the opportunities to finance Russia’s export machine in natural resources. And European banks dominate their financial markets, unlike the US, so any hit to European bank profits has a large impact on the European economy and by extension the global economy. As S&P notes:

“French banking group Société Générale SA, Austria's Raiffeisen Bank International AG and Hungary-based OTP Bank Nyrt., which have some of the largest exposures to Russia among nondomestic lenders, moved in recent days to assure investors and analysts that they could absorb the potential loss of their Russian units without any significant threat to their financial stability... The three banks' share prices plunged by an average of 33.9% in the week following Russia's invasion of Ukraine compared to 16.3% for the Euro Stoxx Banks index…Russia has been a highly profitable market for foreign banks in recent years.”

So while these banks may not suffer a catastrophic drop in their capital levels, their ability to make money and build capital will be restrained, ensuring the European recovery is slow. Had Europe a more decentralized financial system like the US, where high profits from investment banking are tolerated ad even celebrated, Europe would be in the same relatively benign position the US occupies. Instead a slower European recovery impacts global growth and consequently the earnings of US MNCs. This is one more reason I expect US corporate earnings estimates to drop in the coming weeks, resulting in US equities looking overvalued relative to the dreadful risks emerging from Putin’s irrationality and malevolence. Expect a major buying opportunity around 3700 in the S&P 500, rather than the current rallies off the lows of two weeks ago.

My current positions include a large cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO.