Our outlook for credit markets in 2010 has been and continues to be one of volatility. From February through almost the end of April volatility had receded, heading back into pre-crisis levels. However, the trials and tribulations of Greece and fears of contagion to Portugal and Spain as well as the Congressional roasting of Goldman Sachs and the looming financial reform bill restored the words of "political risk" to the lips of investors. Remember those words because they are going to be around for a long time.

When market conditions are good, political risk is something that is usually shrugged off, trumped by good earnings and positive economic data. However, political risk has a tendency to creep up on the markets - long simmering problems eventually erupt overturning investor expectations and forcing an assessment of the risk appetite. And in some cases the market "prices in" political risk, though the actual events still function as a shock. The upcoming years will be one where political risk looms larger than in the past two decades and it will add volatility to equity and debt markets. It will also provide opportunities for the nimble.

What kind of political risks do investors need to consider?

1. Euro-contagion and the rebirth of nationalism: Greece's troubles point to the limitations of the European model of peaceful economic development and extensive social net constructed on the monolith of a pan-European identity and common institutions. Part of this model focused on economic convergence - the bringing of the poorer parts of the union up to the living standards of the richer economies. This helped establish a bloc of 27 countries, stretching from the Atlantic to Russia. The current problem is that this union never established a well-defined political center and a blind eye was turned to corruption and failure to make important structural changes in a number of countries, like Greece. All of this worked as long as there was moderate economic growth, easy access to capital markets, and a willingness of some countries' taxpayers to foot the bill for those that still needed to converge. With the Great Recession of 2008-09 easy access to credit evaporated, economic conditions deteriorated, and the willingness of the wealthier countries to subsidize the poorer has given away to the view that they should pull their economic weight. The German hesitancy to provide a bailout for Greece is a clear reflection that the European model is in trouble. We would expect more fractious European behavior in the future as the sovereign debt issue is not going to disappear any time soon, with deep concerns over Portugal and Spain. Europe is shifting - it is a little less "European" and more nationalistic along the lines of individual countries. The Ultimate downside - which we do not see currently - is that the euro-zone breaks up under the pressures of fiscal retrenchment, pleas for bailouts and rising political tensions.

2. Beware the small countries: There is a danger that the debt problems of small countries will spread to the larger. An IMF-EU rescue for Greece could cost over $100 billion. This is for a country of 10 million people and accounting for only 2 percent of the EU's GDP. The questions that immediately follow are how much would it cost to rescue Portugal or Spain? One estimate puts the funds needed to deal with Europe's spreading fiscal crisis at 600 billion euros ($794 billion). It should also be noted that the problems of small countries ripple up to the larger ones - the United Kingdom, the United States and Japan are all sitting on mountains of debt that will have to be repaid at some point. Disruption of global capital markets by sovereign defaults raises the risks for all countries.

3. Angry Voters: With elections coming in the UK (May 6th), Japan (July) and the U.S. (November), there is a risk that political decisions will outweigh sound economic considerations. Take the April 16th decision by the U.S. government to charge Goldman Sachs with financial fraud. It paints the Obama administration as the defender of the American taxpayers against what many believe is one of the most powerful and arrogant institutions that emerged from the recent crisis with record profits while unemployment sits around the 10%. At the same time, it helps raise the political pressure on the Republicans to go along with a financial reform bill, which potentially could ban proprietary trading, curb customized derivatives, and force more derivatives onto exchanges. While reform is clearly needed, there is a risk that anger and political calculation will end up delivering a bill reminiscent of the Glass-Steagall Act (1933) with the intention of breaking up investment and commercial banking. It also points to the ongoing push by the administration to recast banks into utilities - safe places to put deposits and lenders to people and companies, without the dangers related to investment banking. It would also potentially curtail profitability, reduce the ability of large financial institutions to handle the vast new issuance of U.S. Treasuries going forward, and probably force up the cost for borrowers (as the banks would have to make up revenue from somewhere and opt to pass the costs on to their customers). The United States is hardly alone - the anger and pain of voters is readily evident in opinion polls throughout Europe and Japan and clearly complicates the investment environment.

4. Political risk in the Middle East, Pakistan and North Korea: The combination of nuclear weapons (North Korea and Iran), political succession (Egypt comes to mind), and terrorism and threats to the state (Pakistan, Israel and Saudi Arabia) largely defines this category. Most of these carry risks to international oil production and exports, while North Korea represents an ongoing security headache to South Korea, Japan, China and the United States.

Considering the points of potential political risk, one of the scenarios that emerges is a replay of the 1930s - a difficult uprooting period, marred by economic troubles, aggressive nationalism, and a gradual painful drift away from international trade and investment to protectionism and autarchy.

Consequently the deeper into 2010 we go the greater these political risk factors are likely to weigh on global markets. The impact of these developments on markets is dependent on how various governments and international institutions handle the risk. It clearly places an emphasis on the need for ongoing global synchronization of economic policies among the largest economies.Thus far we see the overall direction of the global economy moving towards a self-sustaining recovery. This is positive for markets. Therefore, there is an incentive to policymakers to maintain a coordinated response to the problems as they emerge; otherwise the uncertainties of political risk will haunt investors, companies and people through the rest of this year and into the next. In this environment we have a preference for investment grade U.S. industrials, selected Emerging Market companies and high quality high yield bonds.