Last year’s volatility was mostly due to the euro crisis, though there were other shocks (especially oil during the first quarter). The euro crisis is not over, but most likely its potential for contagion has been minimized significantly by the actions of the European Central Bank (ECB), which we had highlighted as the key pillar in short-term crisis management. For this year, though the different crises in the Middle East are not new, Iran in particular seems to be evolving into a short-term risk for the world and markets.

As we had stated before (see “Euro fiscal union or euro break up” and “A critical moment for the euro), the structural reforms needed to fix the euro needed to be accompanied by liquidity support from the ECB (see “Mario has joined the game”), and only when and if the ECB got involved in a serious manner we could think about a benevolent scenario in Europe. At the end of December the ECB changed tack in a sharp way with its 500 billion euro LTROs, and a similar injection is expected for next week’s LTRO auction. This not only eliminates the bank refinancing risk, but it clearly helped sovereign debt markets in Europe. At the same time, the fiscal and structural reforms needed to make the euro viable in the medium-term seem to be moving along. This is not a simple or smooth process. For example, the sequence of political elections in Europe can delay or change the nature of the process.

France holds presidential elections in April, and German Chancellor Merkel seems to believe that Monsieur Sarkozy is better than Monsieur Hollande for Europe and the euro. Clearly Sarkozy is closer to her views and preferences about the sequence of reforms, especially how austerity and fiscal rules should come before any serious debate on Eurobonds. Hollande is more likely to favor the views of Spain and other peripheral countries that would rather converge to Eurobonds faster.

From a big picture point of view, the risks in Europe are no longer catastrophic. Greece could still default, with or without a disorderly exit from the euro, but the world is now less vulnerable to such a shock. Some fear that Portugal could be next. In any case, Italy and Spain seem to be on a reform path, with new governments focused on such effort, ECB liquidity having an effect on markets perception of those risks. Italy and Spain matter for the global economy. The euro crisis can still produce jitters, or even a serious shock, but the probabilities have changed for the better.

Iran poses a more serious risk, one that is more difficult to analyze and assess. As the world thinks it is closer to nuclear capabilities of its own, the need for action becomes a short-term issue. Israel will not wait forever, and the US presidential elections introduce a non-trivial timing issue that could accelerate this process. Oil prices reflect this, having increased almost 40% in the last 4 ½ months.  An upside shock in the price of oil could threaten the ongoing constant but tepid recovery, even though it is not only relevant the magnitude of this shock, but its tenor. Nevertheless, an important piece of information is that today the world counts with Libyan and that the rest of the OPEC countries could increase their production to supplement Iranian oil if necessary. This type of risk is potentially more sudden, as we can wake up one morning and be already in an armed conflict between 2 or 3 parties in this situation. Military actions benefits from the element of surprise, markets usually don’t.

The difficulty in predicting such an event, which might not even happen, forces portfolio design to be prepared but still exposed. Our portfolios have maintained a balanced position over the last few months, which allowed for the recovery to benefit portfolios, but at a lower volatility cost. The high beta segments of the portfolios do not reach in total 50% (equities, commodities and emerging market currencies). We recently took profits on most of our high beta debt exposure, now left with mostly investment grade credits. Obviously, a high allocation to oil, high cash, and low duration is the least preparation one can make. Duration would most likely amount to a hedge to an oil shock, but we still curtail it due to our views on recovery and potential inflation if a serious oil shock does not materialize. But, again, timing is usually everything in markets, and a risk like this is by nature almost impossible to predict. One can certainly react to it, but reaction is not the winning part of a strategy, though still necessary.

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