The convergence of shocks over the last 2-3 weeks is nothing short of impressive.  Some of the shocks are: the escalation of events in the Middle East (different but concerning, Libya and Bahrain), the potential juncture for the euro with a sequence of high level meetings while a new bailout is about to be needed  (to potentially culminate with announcements on March 25), plus the horrific events triggered by the earthquake in Japan. World markets have had 3 weeks of a roller coaster that confirms 2011 is bound to be at least as volatile as 2010, if not more. We have done only marginal changes to portfolios throughout these weeks, as we do not see any of these very important events as yet having enough of a permanent effect to warrant a modification of our medium-term strategy. Our risk exposure is still not an aggressive one, which is why changes were not needed.

Let us review a few of the important phenomena that need to be evaluated when deciding on portfolio allocations. This is a quick review of our views, opposed to an elaborate explanation of the whole arguments behind them. We have communicated to clients over the last 2 weeks the foundations of our decisions. This is a summary.

Japan’s earthquake

The Tohoku earthquake is a very sad event, with shocking human implications. However, the medium-term economic impact on the global economy is bound to be small. The region affected amounts to 6-7% of Japan’s GDP, housing and capital stocks, and population. The nuclear situation appears to be finally under control. The first estimates of the cost of the quake are in the $200-300 billion range (3.5-5% of GDP). Though Japan has a compromised fiscal debt picture, it is one of the richest countries, with the capacity to rebound from this crisis. We had not had any direct exposure to Japan before March 11, but did buy the Nikkei on March 15^th in portfolios with the appropriate risk profile for volatile tactical moves.

Oil and the Middle East

This is the key risk for global growth. Though still not a serious threat, it is a serious risk to monitor. As we have already stated, we see the events in Libya as an extreme event. The Arab League’s request for a ‘no-fly zone’ over Libya is a historic event, and helps us feel a bit more optimistic about the reform prospects in the region. We believe that only a persistent and more extreme oil shock can affect the current economic recovery. However, we are concerned about the spread of the conflict. Bahrain and what it could mean for Saudi Arabia is one angle of our concern. The Libyan example, though an extreme case, makes us think about other still low probability but much more damaging events in countries like Iran or Syria. If popular unrest were to get momentum in either of those two countries, the Libyan path is maybe as likely as the Egyptian path to reform. We maintain a close eye on the Middle East situation. Portfolios now have a larger exposure to energy, but a serious oil shock would require more serious reallocations across the board (reductions in Asia and EM equities, etc.).

The events in the Middle East have the potential to derail global growth if the unrest spreads to larger countries, destabilizing places like Saudi Arabia, Iran or Syria. A third military conflict in an Arab country is not a simple un-noticed fact (Lybia), but if it were to resolve faster than the other two and not spread to larger more strategic countries it could still probe to be a transitory shock.

Reforming euro institutions

Portugal is closer to following the path of Greece and Ireland and require/get an EU bailout. At the same time, Spain is doing progress to get away from that fate. The sequence of high-level EU policy makers meetings has so far provided decent to good signals to the markets. Last night we learnt about the size of the permanent rescue facility (to be used from mid-2013). This weekend could prove to be a defining moment not only for Portugal but also for reforming the institutions underlying the euro. It seems the current rescue fund could get larger and more flexible (at least it would be able to buy bond from troubled countries in their auctions, but not in the secondary market as the ECB already does). The recent appreciation of the euro vis-à-vis the dollar has more to do with the prospect for higher rates as inflation raises (which is unlikely to happen in the US any time soon) than with positive news about the euro institutions. A debt restructuring in Greece or bank debt restructuring in Ireland are still likely scenarios for the next 2 years (and markets price them as such). The EU seems to signal that it cannot happen before mid-2013, but markets do not seem to believe that. We remain skeptical of a timely smooth reform of euro institutions. We believe it is still the most likely scenario at the end, but it will suffer from coordination failure, as politicians are bound to get it wrong before getting it right.

US fiscal challenges, from local to federal

The US continues to be the last large country to address its fiscal situation. Its policy mix continues to push the boundaries of macroeconomics. However, the debate is clearly focused on preventing a fiscal crisis, which we believe is still unlikely to happen in the near future. The dollar has and continues to lose ground to other currencies (see our previous note ‘Euro: 2 weeks of meetings can matter’), but will not lose its place as reserve currency. The events in Wisconsin, as well as other states producing not only budget cuts but reforming labor relationships within the public sector, show how the debate is plowing along with facts. At the Federal level there is less progress, as the deadline for a new budget and re-establishing a debt ceiling keeps getting postponed.

Capital reallocation and EM policy challenges

The reallocation of capital away from emerging markets into developed markets has been a strong and serious phenomenon at least since December 2010. The relative outperformance of G7 stock indices vis-à-vis EM indices has been stark. The combination of higher inflation in emerging economies with better economic data in G7 economies explains most of it. Fears of higher interest rates affecting growth or pushing EM currencies too strong for growth to be sustainable remain, though inflation is gradually probing not to be getting out of control. The volatility since the Tohoku earthquake does not allow for a reliable read, but we believe that the large reallocation is behind us, and emerging equity markets are likely to recover some if not all the ground lost vis-à-vis G7 equity markets. This is of particular interest to us given the portfolio allocations to EM/Asia equities in our portfolios. We see the currency appreciation in emerging economies as an inevitable byproduct of their growth and convergence in a world of G7 indebtedness and fiscal deficits. We believe that the real appreciation of those currencies could happen mostly through inflation than further nominal appreciation, which is a challenge for portfolio construction.

In sum, we believe we are bound to recover from the worst post-Tohoku quake, and remain concerned about the Middle East. We have continued to increase exposure to equities (especially in G7, still with a bias to US markets) and commodities since late 2010, maintained our EM exposure, maintained strict discipline away from duration (especially in G7), got back into the EU and dipped our toes in the euro debt market.