Last Friday’s events in the Middle East had significant effects in the global markets: the S&P dropped more than 1.5%, while the emerging markets indices fell between 2-3%. In this Sunday afternoon, we want to share with you where we stand before markets open tomorrow. The most relevant question is whether events will trigger a major correction or just a spike the short-term volatility. We believe that only if these apparently regional events escalate, they could lead to a global impact on growth and companies’ earnings. In the short run, we believe that it will only produce a marginal reduction in risk, especially for those investors who believed that emerging markets were already ahead of the data.

Let’s focus on some ideas and facts, let’s start with the short term, medium term and some fundamental themes:

-Egypt is not a big producer of oil, but it controls the Suez Canal, used to transport 1/3 of the traded oil. Under the extreme scenario where the canal closes, alternative routes to the US would require 10 extra days and 18 extra days to get to Europe. There are reports that show there are sufficient stocks in both the US and Europe, in case serious delays in the delivery of oil. In the worst-case scenario, the US has an emergency reserve set up by the government. Therefore, an extreme case of shortage is highly unlikely, even if the Suez Canal would be closed.

– Oil prices can continue to climb. It is generally understood that only large and persistent increases in oil prices have an impact on economic growth. A short-term spike does not end up affecting growth. Many cite the empirical evidence, in which a 10% price increase during a quarter can translate in a reduction of growth of 0.25%.

-Hosni Mubarak (Egypt’s president) gave a speech on Friday, and he did not acknowledge the demonstrators’ demands. In addition, he named the first vice president in 30 years (Mubarak was the last vice president 30 years ago). He named a man from the central intelligence agency with a military background. The armed forces are better perceived and have greater approval rates than president Mubarak. The violent events that are seen on television are mostly executed by the police and not the armed forces. In fact, there has been cooperation between the protesters and the armed forces.

-Furthermore, yesterday, Egypt’s ambassador to the US said that the armed forces are a crucial institution for the process of a peaceful continuity of Mubarak’s ruling. A transition towards free elections under the armed forces supervision appears to be the most attractive scenario for the rest of the world, and also it appears to be the most likely outcome.

-Maybe as in the euro crisis, we could be in the initial stages of a domino effect. The protests that started in Tunisia are being followed in Egypt and to a lesser degree in Yemen and Jordan. It appears that the domino effect is only happening in the western countries’ allies, but it is easy to think that all countries are potentially exposed to such events, in particular in modern times where the information flows quickly through Facebook/Twitter/Al-Jazeera. The television/Internet/SMS have played a major role in these events.

-The biggest risk is that the region’s instability will increase the uncertainty with regards to the overall political situation. Israel is located between two moderate and western allies (Egypt and Jordan). If the governments of those countries were to change, the region’s stability would most likely change as well, even though Israel already coexists with less friendly countries at similar distances like Syria, Lebanon, etc.

-A scenario that worries the western world is the possibility of a revolution like Iran’s, with a similar type of outcome. On the other extreme, a positive scenario for the markets is one where Egypt has free elections and the winner is somebody with a profile like ElBaradei (Peace Nobel prize winner and ex head of the UN’s nuclear control agency) who is back in Cairo participating in the demonstrations and asking for Mubarak’s resignation. In fact, ElBaradei made a speech in one of Cairo’s central squares, where he said that the opposition leaders have asked him to become the unified voice of the opposition parties and to put together a transitional government.

-Egypt is an important ally for the US and has brought moderation to the negotiation table for Middle Eastern conflicts. The US is trying to keep a balance between supporting democracy and freedom, while not being too outspoken about requesting Mubarak to step down. It is quite clear that Egypt is a very relevant country for the region. Some have compared these demonstrations to Berlin’s.

-We pay special attention to the armed forces, given that their high reputation might provide them the necessary political approval to carry on an orderly transition.  All scenarios are possible at this point. Even though we are not experts on this field, we believe that the likelihood that a year from now Egypt becomes like Iran seems smaller than the likelihood that Egypt becomes Turkey.

What should we do under these circumstances?

As we have expressed in our monthly letters to clients (and to some extent in our site), even though data about fundamental growth should translate into a portfolio exposure of more than 30% in stocks and more than 10% in commodities, our portfolios remain more conservative given international risk (euro, US fiscal situation, currency war). The political risk (either between countries or within a country) always exists, but the specific details are almost impossible to predict. The events in Tunisia triggered the debate about the potential implications on the rest of the region. The increased uncertainty tends to generate a portfolio risk reduction, which usually produces negative convexity (selling assets at the lows only to re-purchase them higher). We have not reduced because if this reason and the facts above. We will monitor the situation and if the events in Egypt take a significant downturn, we will be ready to reduce our portfolio risk.  The Middle Eastern markets (that are open on Sundays) have plunged. Given Friday’s major stock markets performances and given the nature of the events, we believe that we are very far away from real and permanent slow down in global growth. We expect a short term effect in the markets, we are thinking of a 1-2 week impact.

[ this is an excerpt from an email sent to our clients in the afternoon of Sunday January 30, 2011 ]