Our first reaction to Egypt (to read that post click on ‘Our first reaction’) and the approach thereafter proved to be the right, so far. However, we do think the events in Tunisia and Egypt introduce a new theme that was not there earlier and that merits careful attention. The Middle East is inevitably changing.

It is not difficult to see popular demands spread, as they are doing through Yemen, Algeria, Jordan, etc. The demonstration effect is huge, and the combination of Facebook/Twitter/Al-Jazeera that helped transport the phenomenon from Tunisia to Egypt is bound to continue to work in the same fashion. We subscribe to the notion that this could be similar to the Berlin Wall falling, but for Middle East regimes. This new theme opens a plethora of possible scenarios for the region, and each country in it, with potentially relevant market implications. It is easy to underestimate the meaning of what we have just witnessed: a 30-year regime in a large stable country like Egypt was forced to change in a matter of 2 weeks. This is already a historic event for Egypt, and could be a historic year for the region.

At the beginning of these events there appeared to be a pattern in the works: low GDP per capita, high unemployment (especially youth-unemployment), no sharing in oil bonanza (social programs or other type of transfers), and high food inflation. Tunisia, Egypt and Yemen have much of the picture in common. But recently we have seen some demonstrations in Bahrain (with a PPP adjusted GDP per capita of $24,000/year). The forces at play here (boosted by the Facebook/Twitter/Al-Jazeera troika) could very well produce problems for any regime in the region, or anywhere else.

Most likely, the combination of oppressive regimes with low GDP per capita and high unemployment produce the majority of the ferment in which these ‘revolutions’ happen. But food inflation is also a part of it. As we have already stated, EM inflation was only interrupted by the crisis, as it was already a problem right before the end of 2008. Inflation is the key reason that EM equities have seen drastic outflows in the last 1-2 months. We see that as an over-reaction unless inflation gets closer to 10% or higher. But yet another issue to be monitored.

It is important to balance the analysis, despite the natural tendency to think of the Middle East and think of instability. There are very positive scenarios in which the transition leads to freer societies, which would produce freer and more efficient economies that entice capital inflows and investment. Most likely we will see some countries go through such positive scenarios, while others show much more unstable dynamics out of their regimes.

In our previous note on Egypt (cited above) we mentioned that Egypt is not an oil producer, though one-third of the oil traded in the world goes through the Suez Canal. We quantified what an interruption in the Canal services would mean. However, Egypt being a large and politically relevant country in the region, its transition matters (beyond its Peace Treaty with Israel, though the issue starts there). When looking at the vulnerable countries in the region, the oil producers attract the most attention (though the large ones do not suffer from low GDP per capita or high youth unemployment). Iran is another focus point, for obvious reason.

When we published our medium-term views in early January this was not one of them (see it in our ‘Focus Pieces‘ section). Now it is a theme, one that requires attention. Events in the politically/economically relevant countries need to be closely monitored. Oil prices are bound to stay well bid given the combination of better global growth and this theme. Inflation in EM has to stabilize in reasonable levels (below 10%, if not well below that). In the meantime currencies are gaining value vis-à-vis G7-currencies in real terms, no so much nominal terms. The outlook for 2011 has just gotten a bit more interesting, which means we could have a repeat of a volatile year (as 2010). Or maybe this is how the post-crisis world will look like for many years to come…