by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Welcome back from the long weekend!  Here are the stories that caught our attention:

A break in Europe: Chancellor Merkel made headlines by indicating that, in the wake of the G-7 meeting, continental Europe must prepare to “go it alone” without the security support of the U.S. or U.K.  During his trip (and in an early morning tweet), the president called Germany “bad,” criticizing the nation’s trade surplus with the U.S. and its defense spending coming in below the 2% NATO target.  These are all legitimate concerns.  However, we fear it has been forgotten why we are in this position at all.  After WWII, the U.S. was not looking forward to fighting another war in Europe.  Thus, the U.S. created NATO, which America has dominated, and effectively disarmed the continent.  In other words, we purposely created conditions in which the Europeans spent less on defense and made them dependent on the U.S. for security.  Although this was an expensive policy, it did work.  So far, we haven’t fought WWIII on European soil.  If Merkel is true to her word, Germany should rebuild its armed forces.  Although this may be what the U.S. wants on the surface, Germany will be less likely to follow American foreign policy once it has a formidable military.  Such fears seem farfetched given the current state of European militaries, and they probably are in the short run.  In the longer run, however, a remilitarized Germany is a grave concern.

Draghi remains dovish: The ECB president indicated that the Eurozone still needs “an extraordinary amount of monetary support.”  ECB policy has increasingly come under fire from German officials who want policy to tighten.  Draghi did acknowledge the Eurozone economy is improving but expressed concerns about continued low inflation.  On a related note, the ECB has been reluctant to buy Greek bonds until the current bailout is resolved.

A Greek scare: There were reports overnight that seemed to suggest Greece was preparing to default on its debt if a bailout deal wasn’t reached.  The EUR plunged on the news, but we have seen a recovery after Greek officials clarified that a default wasn’t being considered.

Italian elections: By February 2018, Italy will need to hold elections.  However, the major parties are considering early elections tied to a change in electoral law.  The proposal would be to use a proportional system similar to Germany’s that prevents any party that gathers less than 5% of the national vote from seating candidates in the legislature.  Although a proportional system would improve the stability of Italy’s political system, a vote could bring the populist Five Star party to power and raise fears about Italy’s commitment to the Eurozone.  Meanwhile, the NYT is reporting that the Russians are taking advantage of the Trump administration’s distractions elsewhere and building relationships in Italy.[1]  The aforementioned Five Star movement not only wants to hold a referendum on the Eurozone but also calls for closer relations with Russia and a reduction of American influence in Italy.

U.K. elections: Debates were held over the weekend and were essentially called a draw.  The polls are still tight; the latest show the Tories with a 6% lead over Labour, which is stable but close enough for discomfort.  If the polls remain this tight, the best we can hope for is that the Conservatives hold a small majority in Parliament.  This outcome would hamper May’s ability to negotiate exit conditions with the EU.  The second worst outcome would be a hung election where no party is able to cobble together a government.  The worst outcome for the financial markets would be a surprise Labour win.  In some respects, a Corbyn-led Labour Party win would send a clear signal to the world of the unpopularity of globalization and indicate that the post-Cold War “Washington Consensus” is probably finished.  Although we don’t expect a Labour win, the polling frankly bothers us because we wonder about preference falsification; Corbyn is a divisive political figure and we worry that he might have more support than people will admit to poll takers.

A second Korean War?  The U.S. is sending the U.S.S. Nimitz carrier group to northern Asian waters, perhaps joining the U.S.S. Carl Vinson and the U.S.S. Ronald Reagan.  It is possible that the Nimitz, which was originally scheduled to go to the Middle East, is going to relieve the Carl Vinson.  However, the U.S. tends to prefer to have three carrier groups in a region when it goes to war.  Having three groups makes it easier to conduct round-the-clock operations if a hot war erupts.  We suspect that SOD Mattis is putting the pieces in place for President Trump if he decides to attack North Korea.  We will have more to say on this issue in the coming weeks but the North Korean situation has evolved to a point where, if nothing is done, the Hermit Kingdom will be able to launch missile strikes on the U.S. itself.  We don’t see war as imminent (next six weeks) but the odds of conflict are rising.  Perhaps the carriers are the best clue—if three remain in place, it does indicate that the U.S. is moving to a war footing.  That signal may be designed to encourage the Kim government to the negotiating table or scare China into pressuring North Korea.  But, the stronger the signal the harder it is to “walk back.”

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[1] https://www.nytimes.com/2017/05/29/world/europe/russia-courts-italy-in-us-absence.html?emc=edit_mbe_20170530&nl=morning-briefing-europe&nlid=5677267&te=1