The volatility of the last few months made many people believe 2012 would be a repeat of 2011. We do not see much value in looking for insight about the future in past patterns or charts. A lot has changed since last year, though the main risks remain the same. We believe the risk distribution has changed towards a couple of extreme scenarios, which means the base case scenario is better than what it was a month ago. In other words, we went from leaning towards further risk reductions to leaning for risk increases, within a cautious approach.

For many months now the key global short-term themes have been: the euro crisis (in its many different forms, Greece, Spain, Italy, German politics, etc.); the Chinese and American business cycle/s; the US fiscal outlook (or risk of sharp adjustment, as the ‘cliff’ refers to); and, Middle East conflicts and instability. These have gone up and down in relevance over the last months, but they remain up there in the list of key market concerns.

Last month we wrote that the Spanish banking bailout was important, but not a game changer. What happened recently between Spain and the EU comes closer to being a game changer. Spain has received concessions on the timing of its fiscal adjustment, as well as potentially not having the bank bailout in the sovereign books, in exchange for an agreement that is not far from the commitments it would have had to sign for a full blown bailout from the troika (IMF, EU and ECB). Thus, we tend to agree with those that see something close to a game changer in the case of Spain. More details and implementation are needed before anybody can think of Spain as a lower risk focal point, but the tone and direction of the Spain-EU relationship has improved and provides comfort. A month ago it seemed to be a childish fight between pride and petty politics on the one side, versus an obtuse view on incentives and moral hazard on the other (readers should be able to figure out who was who in that fight).

All in all, the policy debate and actions in Europe continue to move in the right direction (fiscal and financial integration to complement the monetary Union), but pace and details are what matter. Most countries seem to be doing progress along their structural reforms and adjustments. Some have even pointed out that Greece has gained competitiveness due to deflation in many sectors. As we said before, there is a conflict between the EU slow and gradual approach and the pace that markets require to feel confident the euro is sustainable. This conflict is bound to re-emerge.

As we said more than a month ago (here and in client letters) the Chinese business cycle is hard to judge. We believe China is a large experiment in economic convergence. Markets and most observers continue to believe that lower growth rates are the result of contractionary policies, which can be reversed by pushing the lever the other way. That the government can again engineer growth rates closer to 10%. We believe that China will at some point converge to more normal growth rates in the range of 4-7%, as no country has been able to grow above that for long periods of time, and higher rates are mostly associated with convergence (the process in which investment leads a poorer country to catch up with developed countries). It is difficult to assess whether that convergence to lower growth is now. What is clear is that if it was now, the world is not ready for such scenario, as most expect growth to go back to the 7-10% range. This is a risk that concerns us, mostly due to its impact on expectations, which is why data watching has become key.

The US calendar shows two important events towards year-end: the presidential and congressional elections, as well as the so-called ‘fiscal cliff’. The latter is basically a very large fiscal adjustment that would happen automatically unless congress changes the laws that were passed when Obama extended Bush’s tax cuts as as the spending sequestration that was set in place when the debt ceiling was moved up last year. It is a bit ironic that we have gone from fearing the effects of fiscal deficits and debt to fearing the effects of a large fiscal adjustment that is already in the laws. But the prevailing view is that the US economy is already growing at a very low rate, and that a sudden fiscal adjustment would push it into recession. The important point here is economic uncertainty about taxes, given that congress is unlikely to do anything until after the presidential elections (early Nov.), or maybe until January.

With 10-year rates at 1.5% it is not difficult to see the US has little incentive to produce a meaningful fiscal adjustment. But the key here is whether the fiscal cliff would produce volatility in the markets, a mini crisis, which pushes politicians to sit down and produce a better designed tax reform and medium-term fiscal adjustment. As we have said many times, the ideas for tax reform and medium-term fiscal solvency are on the table, and the debate on them has been and will continue to be at the forefront. Our base case scenario is of a very positive medium-term for the US economy. But the short-term could again produce a self-imposed mini crisis due to these somewhat childish masochistic deadlines the political system set for itself.

The Middle East is where the tail event risk lies. Syria, Iran and Israel can produce sudden shocks that push oil prices higher again, and de-stabilize markets. This risk had abated for a few months, it has now come back. Syria’s opposition is gaining strength, which means the conflict is heating up, which means a resolution is closer, but also shocks. There are official reports about the Syrian government moving stockpiles of chemical weapons, without clarity on the intent. In the case of Iran, though Israel seems to have put off a pre-emptive strike on nuclear facilities, multilateral negotiations do not seem to be conducive while the pain of economic sanctions can lead to conflict in the Strait of Hormuz. The US has been beefing up naval resources in the area.

Concluding, we see the economic risks (especially Europe) with a lower potential of a big shock in the very short term, but a higher (still low) probability of short-term shocks from the Middle East, which justifies a continuation of out cautious strategy. So far this year, our returns have exceeded most international equity indices and compare well with balanced indices.