Over the last 10 days a sequence of shocks have shaken confidence on the recovery. Those shocks have more of an impact on sentiment than on the fundamentals that comprise our medium-term base-case scenario. But the market impact of those shocks has been significant, which is why a reassessment of that scenario is due.

The list of shocks is: 1) policy announcements out of China that aim to decelerate its recovery; 2) Obama’s announcements on its financial reform plan, which aims to shut down proprietary trading within banks and reduce their overall size; 3) the surprising difficulties in getting Fed Chairman Bernanke confirmed by the senate for a second term. On top of those 3 shocks, economic data in the US has disappointed to some extent (after more than 2 months of positive surprises), while corporate earnings continue to outperform estimates on average. Economic data from Asia, especially trade, continues to outperform (except that from Japan), while that for Europe provides marginal negative surprises. Equity market valuations in the US and Asia continue to be moderate in terms of expected earnings (especially after the selloff of the last 10 days). The S&P500’s P/E ratio is below 14, that of Asia ex-Japan below 15 (with South Korea below 12, Thailand below 11, etc.), that of Latin America only 13. Only the latter is above one standard deviation from the last 10-year average, which is easily understood in terms of the convergence trends in Brazil, Colombia and Peru (while Chile’s P/E is 7-8, half its 10-year average). When we look at these numbers in the context of the current stage of the global business cycle (should we say recovery), combined with concerns about inflation, we can easily conclude that our portfolios’ exposure to those markets is a moderate one.

Of the three shocks above, Obama’s announcements on his financial reform proposal is the most concerning of them all. This is not because of the impact of that reform, or its probability of being enacted, but because of what it shows about the President’s policy inclinations. The shape and tone of that proposal espouses a clear populist turn as a political strategy to recover from his recent failures (healthcare reform, elections in Massachusetts, etc.). This financial reform, as just announced, would be difficult to enforce, and as such unlikely to be approved. However, Wall Street is an easy target these days. Yesterday’s State of the Union address showed a combination of pragmatism with populism, which allows us to be optimistic about the message that the next congressional elections can send at the end of the year.

In terms of China’s efforts to cool down its economy, the measures aim to moderate growth in bank credit, which if it were to continue at recent rates would take the aggregates to ridiculous levels relative to any economic variable. Such credit growth can easily blow a bubble in local financial and real estate assets (inflation is almost at 5%). We do not expect Chinese growth to plummet, but to moderate (2008 growth has just been reported at 10.7%). Asia has so far shown the clearest signs of recovery, and it is where policymakers are bound to continue withdrawing the stimulus enacted during the crisis (trade in the region grows now at an annual rate of about 40%). We expect currency appreciation as well as growth continuity in the region.

On Bernanke’s confirmation troubles, we believe it is just an attempt by the opposition to complicate Obama to some extent, but expect his confirmation to happen over the next few days. Paradoxically, the Fed Chairman originally nominated by a republican president is being questioned by the republican party.

None of these 3 shocks has the potential to change the medium-term scenario: continued economic recovery in G7, though at a lower pace than growth in Asia and other G20 countries (not in G7). However, the market performance of the last 9 months is unlikely to repeat itself (in terms of returns).  Baffin’s model portfolio, which started on July 9^th of this year, has had a total return of 14.5% so far, but -0.8% year-to-date (COB January 26). The S&P500 has fallen 2% year-to-date, European markets have fallen 4.5% while Asia ex-Japan fell 5.4%. Our portfolios have almost 30% in stocks globally (across the US, Asia ex-Japan, BRICs and the S&P100 global companies), about 105 in commodities (across energy, agriculture and materials), about 40% in fixed income (with currency and regional diversification, low duration, and including inflation linkers). The rest is in cash and other investments. With the benefit of hindsight (the effects of Obama’s recent announcements), a reduction of equity and commodity exposures would have served the portfolios well. However, attempts to time the markets at high frequency are usually more costly than beneficial, especially if the medium-term scenario has not changed yet.

We continue to monitor global macro developments as well as corporate earnings, in order to reassess our view vis-à-vis data and policy decisions. What we have changed recently is the allocation to inflation linkers and technology (increasing exposure in both). We have reduced duration even further.