Markets in March seem directionless, confused. There are a few important issues that provide reason for caution. None of the issues that cause concern are new.

Last week the Fed decided to provide its first signal that it could rid markets from its ‘training wheels’ when it characterize the economic situation as improving, including the labor market. Given the markets’ dependency on central bank liquidity since the 2008 crisis, one would have expected a negative reaction to such event, but it coincided with the release of banks’ stress test results, which allowed some banks to announce dividends and buybacks. Since that rally on March 13^th, the S&P has not moved much. There is never a controlled experiment in markets, but what happens as the Fed gradually signals liquidity support is to be withdrawn is very relevant, after more than 3 years of strong dependency on central bank liquidity provision.

China is showing signs of deceleration from its abnormally high growth rates of 8-10% towards 7%. Markets fear this as a tectonic shift. Many argue that economic activity would recover towards 10%, some think policy makers are bound to stimulate the economic towards that goal. We see Chinese growth as inevitably converging to a more normal range, in which 5-7% is already the high end. When that convergence happens is very hard to say, as it is very hard to analyze and understand such a complex and gigantic economy, undergoing an unprecedented process of managed liberalization. However, there are a few economic phenomena worth mentioning. Real exchange appreciation is happening mostly through inflation (and wage growth), while G7 continues to ask for nominal appreciation (which has happened very slowly). The fact that the last few years showed the first labor disputes and wage hikes, confirm what we have heard from Chinese officials in international fora: there no longer is an infinite supply of labor from the country to the industries in the shore states, which leads to rising labor costs, which are producing the real exchange rate adjustment that the world demands.

Thus, from a big picture point of view, China is most likely converging to a more conventional growth range, in which 5-7% is the high end, at the same time that constantly low prices for its products is no longer possible. On the one hand, 5-7% of a much larger economy could be equivalent to the 10-12% from 5-10 years ago, in terms of the impact in the rest of the world. But in the meantime, markets could over-react to lower Chinese growth. On the other hand, a real exchange rate adjustment in China could mean inflation in manufacturing goods globally. These are important medium-term themes.

The other two themes to keep in the radar with respect to China are: potential political instability and internal credit quality. As we highlighted last year when the Arab Spring started, the elephant in the room when it comes to thinking of a population demanding political freedom is China. It is difficult to believe that what happens to every country as it develops would not happen to China, thus the question is when and how the political system will open up.

On the credit side, China has an investment rate of 45% of GDP, and that investment is to a significant extent ‘directed’. Chinese banks have loans in their books that reflect many of those investments. In other words, very large amounts of investments have been made according to decisions that not necessarily respect market prices and cost-benefit analyses, and banks have financed such investments. In 1998 we experienced the results of directed investments in Emerging Asia. It is highly likely that an economic deceleration shows the inefficiency of a non-market asset allocation, some investment projects fail, and non-performing loans increase within the Chinese banking system. Given the overall balance sheet situation in China, a serious crisis is not likely, but global markets are bound to feel rattled about higher non-performing loans in such a large economy.

Finally, the rise in oil prices since October of last year is making some people believe 2012 could be like 2011, in terms of an oil shock killing the global business cycle. Last year’s oil shock was more sudden, and was accompanied by the earthquake/tsunami/nuclear crisis in Japan, the sequence of euro crises that could have dismembered the union, the Arab Spring and political instability in the Middle East, the US debt ceiling noisy debate and later the Thai floods. This year we have higher oil prices, which happened more gradually, with a risk of a shock if a conflict between Iran and Israel materializes.

In a recent letter to clients we discussed the Iran-Israel issue in some detail, which it is ultimately difficult to assess and predict. The important issue here is that we seem to be at a critical point in the global business cycle, with better fundamentals than in 2011, but still some concern. The data flow was clearly better until very recently, that some slight tilt in the trend appears to emerge. In the short-term, we maintain our cautiously optimistic stand, and watch the global business cycle. The themes mentioned above are very relevant when designing portfolios and thinking about the medium-trend.