by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] We are seeing a rebound in risk markets this morning as there is growing speculation that the U.K. and the EU will be able to negotiate an acceptable deal.  This sentiment is rising despite comments from Chancellor Merkel indicating that there will be no “cherry picking” EU rules.  One tactic that appears to be developing is that the process of exit won’t start until an Article 50[1] request is formally made by the U.K.  Since the U.K. only has a temporary PM, nothing will formally begin until a new PM is selected.  There is growing sentiment to push Labour Party leader Corbyn out of his post to allow the party to select an establishment figure.  This new shadow PM would likely call for a vote of no confidence on the new Tory government and, if it wins, elections would be held.  Labour would likely run on a platform to reverse the Brexit referendum and it might win.  It is not clear if the establishment can reverse the outcome of last week’s vote, but it is beginning to look like it will be delayed for a while which gives markets some breathing room.

Going into 2016, we noted that there were four “known unknowns.”  The first on the list was monetary policy.  Brexit, along with sluggish growth, has mostly taken further policy tightening off the table.  As we note below in the Asset Allocation Weekly section, St. Louis FRB President Bullard’s recent changes will probably act to keep the Fed on the sidelines this year.  Our second unknown was the global economy.  Brexit highlighted the risk from this issue, although China remains a concern as well.  However, if Brexit is delayed significantly and global central banks remain accommodative (which seems to be the trend), the global economy will probably hold up.  The upcoming U.S. election was third on the list.  This remains a risk and may be the biggest risk we face this year.  Polls suggest Donald Trump won’t win, but polls have become remarkably unreliable due to a political science thesis known as “preference falsification,” which means that, under some circumstances, social pressure leads people to make public statements that are contrary to their private preferences.  Under conditions of preference falsification, unexpected events occur because voters hide their real intentions.  Surprises like Brexit or Sanders and Trump occur.  Under these conditions, it becomes nearly impossible to accurately determine the degree of discontent with the established order.  Thus, going into the Brexit vote, the financial markets had discounted a remain vote only to be caught on the wrong side of the position.  This risk exists in November as well.  The fourth unknown is geopolitics, which remains a wild card as it is unclear if U.S. enemies will act before a new president takes office.  If the world believes that Sen. Clinton will likely prevail, nations like Russia or China might become more belligerent on the idea that the current president is less likely to respond than the next one.  We monitor this risk closely but it is very difficult to predict with any accuracy what might happen and when.  About all we can say is that risks are elevated.

So, bottom line, removing the Fed from the situation is supportive for risk assets.  The world economy will probably be ok, too.  However, the elections and geopolitics remain a concern.  This probably means we won’t have a return to the earlier lows in equities, but the upside is probably limited also.

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[1] The article in the EU charter referring to a nation exiting the body.