Daily Comment (July 11, 2016)

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There is a lot of political news this morning, all of it from abroad.

Leadsom quits: The race to replace PM Cameron ended this morning when Energy Minister Andrea Leadsom quit the race, leaving Home Secretary Theresa May as the only remaining candidate.  Almost immediately, the GBP rallied as did U.K. equities.  In this week’s WGR, we discuss the post-Brexit situation.  One of the key points of our analysis is that the referendum was not the final word; Reuters reports today that over 1,000 prominent British lawyers have signed a letter, delivered to PM Cameron, stating that invoking Article 50 of the EU Charter can legally only come from an act of Parliament.  Simply put, it is quite possible that the U.K. never actually leaves the EU.  Although May has indicated that “Brexit is Brexit,” she supported the Bremain campaign and it would not be a surprise to see her press for a vote in Parliament to thwart the results of the referendum.  This may require an election to pull off, but the bottom line is that Brexit, if it does actually occur, may be months or years away.

Abe wins: In Sunday elections, PM Abe’s LDP won a clear majority in the upper house, gaining over two-thirds of the seats.  This power will allow Abe to press ahead with constitutional revisions.  Although there is great concern that Abe will try to end Japan’s pacifist constitution, we doubt he will make this move without a stronger economy.  There is talk of fiscal expansion; again, we doubt this will be the end of it.  According to reports, former Fed Chairman Bernanke is visiting Japan to meet with officials today.  As we noted in our WGR series on direct central bank financing of fiscal spending, or “helicopter money,” we argued that the first nation most likely to deploy this funding program would be Japan.  This vote brings that possibility closer.

Tribunal judgment tomorrow: The International Tribunal for the Law of the Sea at The Hague is set to announce its verdict on the Philippines’ claims that China has violated the law based on its “nine-dash line,” where China claims virtually all of the South China Sea.  It should be noted that the claim is not over competing sovereignty issues but over maritime rights attached to each claim.  It is expected that the tribunal will rule in favor of the Philippines.  China has already indicated that it will not abide by the tribunal’s ruling, arguing it lacks jurisdiction.  The U.S., which is not a signer of the Law of the Sea Treaty but generally abides by its rules, is the only power capable of enforcing the court’s claims if they are adverse to China’s goals.  The U.S. has increased its naval presence to signal to China not to react aggressively to the ruling, but escalating tensions cannot be ruled out.

The financial markets are reacting positively to the news out of the U.K. and Japan.  Risk assets, such as equities, commodities and foreign currencies, are rallying while safety assets, such as gold and Treasuries, are retreating this morning.  Although May’s “coronation” is initially positive for risk markets as it reduces the odds that Brexit is actually implemented, her mandate is less secure by not having a leadership vote.  Thus, she may need an election to actually secure a mandate.  Not only could she run to oppose Brexit, but elections would further delay an Article 50 declaration.  Anything that puts off Brexit is bullish for the GBP.

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