Geopolitical Developments: As Boris Johnson Goes The Watch Now Turns To Mario Draghi, With Even Greater Consequences For the Global Economy

This morning’s news of Shinzo Abe’s assassination is a reminder of how quickly political shocks can occur, coming so soon after the tumultuous downfall of Boris Johnson. So far the markets have shrugged off these political earthquakes as the focus remains on the resilience of the global economy and the profit expectations of MNCs. The volatility risk premium points to a higher market over the next few days, while my technical reading of key stocks in the S&P 500 is near-term bullish but intermediate-term bearish. Yesterday's action across fixed income, currency and commodity markets signified no meaningful changes to the global macro environment. Expect the S&P 500 to be range-bound over the next few days before falling steeply into the second half of July.

With war fatigue growing the political reversals are just beginning, as disaffection over inflation and past policy mistakes destabilize European politics. Boris Johnson was precisely the John Bull leader the UK needed yet his inability to do anything about inflation combined with his sense of privilege unwound his support, and the same may happen in Italy to Mario Draghi. But instability in Italy would send financial markets lower since that magnificent nation is sadly the sick man of Europe, while BJ’s ouster meant relatively little to anything but the £. Europe is hostage now to energy markets, the weather and Ukraine’s military resilience, and should these disparate vectors continue to worsen then a far-right government in Italy becomes unnervingly plausible.

The problem this poses for the global economy and financial markets is that Italy is badly in debt to its European siblings. Reuters notes Italy’s target2 debt reached its highest level at more than $600b, which means that capital has been flowing out of Italy to Northern Europe, but central bankers have covered for Italy so that its liquidity remains neutral. At some point European leaders will demand Italian leaders turn around their moribund economy, and should a neo-fascist nationalist like Giorgia Meloni take over Italy, that would be grist to her mill. Financial markets would then factor in denomination risk (i.e., Italy leaving the eurozone) and that would trigger fears of defaults on Italian debt and cross-defaults among both strong and weak Italian banks whose bonds have legal provisions tied to defaults in foreign exchange and interest rate swaps. From this complex financial scenario emerges an Italy forced to bring back the Lira, and the fracturing of the EU. Nothing could boost Putin more.

This in turn solidifies the Ukraine War as a hot conflict, furthering war fatigue and emboldening the European right and left-wing statists who have sympathy for Putin. The European economy would have a hard time recovering with such bitter politics resurrecting memories of the early 20th century. The hope is that Mario Draghi can hold on by showing results from his centrist policies and his remarkable coalition-building skills. Draghi is the antithesis of fascism, and the world desperately needs the global economy to hang on and give this savior more time.

And for now equities are rallying as the economic trends are not as bad as the political trends. Today’s jobs report signals resilience in America, while European banks once again showed their strong capital backing in the Fed’s recent stress tests. S&P Global notes “Deutsche Bank AG's U.S. unit showed the greatest resilience against a severe economic downturn in this year's Federal Reserve stress test as European lenders outperformed their U.S. peers in terms of robustness of capital.” The hope is that politicians and voters don’t muck up the system and let the global economy adapt to the myriad disruptions that have emerged this year. I see this scenario as plausible, and should it enfold then equities would eventually rally back to old highs. The bear market hasn’t ended yet, but a bottom could be made this month should political heat decline for a few more weeks.

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