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10 Charts That Explained Markets In 2015… And Will Impact 2016

Summary 2015 will be remembered for weakness in commodity markets, which bled over into global equities and U.S. high yield debt. In 2016, the divergence between monetary policy in the United States and the rest of the developed world could shape global financial markets. Underpinning all global markets is the ongoing transition of the Chinese economy from one driven by fixed investment to one led by domestic consumption, an unrivaled economic experiment. Below are what I believe are ten of the most interesting charts of 2015. The topics depicted had outsized impacts on financial markets in 2015, and will continue to be important considerations as the calendar turns to the New Year. While oil stole many of the headlines in 2015, falling by nearly two-thirds over the past eighteen months, a broad commodity index moved to its lowest level since 1999. Industrial metals, precious metals, and agricultural commodities were all pressured by a slowdown in global growth. Global Commodities Trade at 16-Year Low (click to enlarge) Source: Bloomberg, (Data through mid-day 12/24/15) Stress in commodity markets was primarily blamed on moderating Chinese growth. While the Chinese growth rate has receded, the absolute change in the size of the Chinese economy was still roughly equivalent to its absolute growth in 2006 and 2007 when the economy was growing at double digit growth rates. In 2015, the Chinese economy grew in absolute terms by the size of the entire Swiss or Saudi Arabian economies. Said differently, the Chinese economy still grew in nominal terms by the size of all the goods and services produced in Switzerland in a year. The China effect on commodity prices has been less of a function of flagging growth rates, and more of a function of the party’s efforts at transitioning the economy from an investment-led to a more domestic consumption-driven economy. Chinese Economic Growth in Absolute Terms is Still Tremendous Source: Bloomberg, World Bank While China had an impact on commodity prices, the strengthening dollar also was a big story. When the value of a dollar rises, it takes fewer dollars to buy a given commodity. These global commodities traded in dollars also become more expensive in local terms, potentially reducing demand. As the graph below shows, the dollar is at its strongest points versus a basket of global peers in the last decade-plus. As the Fed normalizes monetary policy further, higher interest rates on dollar investments could also spur a rally in the greenback, which could further pressure commodity prices and U.S. exporters and multinationals with large foreign businesses. The U.S. Dollar Index Strengthens Against Global Peers (click to enlarge) Source: Bloomberg, (Data through mid-day 12/24/15) A key theme in 2016 could be the divergence of U.S. and European monetary policy. Lend money to the German government today for ten years, and they will pay you 0.64% per year. In April, that figure was an astonishing 0.075%. That figure is still negative for 10-yr Swiss government bonds at -0.09%, meaning investors pay for the privilege of the Swiss government to hold their money in Swiss francs. Higher interest rates in the United States could continue to rotate money from the low rates in the developed world (Europe and Japan) and more stressed emerging economies. Shifting capital flows will create volatility and opportunity. German 10-yr Highlights Ongoing European Economic Weakness Source: Bloomberg Speaking of volatility, U.S. investors may have been unnerved by an uptick in market volatility in 2015, but that volatility paled in comparison to the volatility on the shallower Shanghai exchange. Chinese Volatility Could be Part of New Normal (click to enlarge) Source: Bloomberg, Standard and Poor’s One of my key themes has been the long run risk-adjusted outperformance of lower volatility assets relative to their higher beta cohorts. I wrote an expansive series this summer on the L ow Volatility Anomaly , or why lower risk stocks have outperformed their higher risk brethren over time. That theme continued in 2015 as a low volatility component of the S&P 500 outperformed high beta stocks and the broader market gauge on an absolute basis. Low Volatility Outperforms (Again) (click to enlarge) Source: Bloomberg, Standard and Poor’s; (Data through 12/23/15) This preference for lower volatility assets also extended to the topical high yield bond market ( as described in this piece ). Driven by the underperformance of commodity-sensitive speculative grade bonds, the High Yield Index is under the most stress since early in the economic recovery in 2009. This stress can be seen by the sharp underperformance of lower rated riskier ratings cohorts versus the performance of the higher rated BB junk bonds. Chasing Yields Led to Bad Outcomes in High Yield Source: Barclays; Bloomberg While the last two graphs compared different quality classes within an asset class, the next graph depicts the volatility of the 30-yr Treasury versus the S&P 500. As one would expect upon the unwind of vol-suppressing extraordinary monetary accommodation, interest rate volatility increased in 2015 as shown by the variability of the performance of long duration Treasuries. For investors seeking shelter from equity volatility in fixed income, long duration securities with higher interest rate sensitivity may not be the haven for you. (This is a topic I have also covered in the past through an examination of the volatility of the bonds and equity of Apple (NASDAQ: AAPL )). Equity vs. Rate Volatility (click to enlarge) Source: Bloomberg; Standard and Poor’s; U.S. Treasury The Fed rate increase was in large part driven by a firming in the labor market that pushed the unemployment rate down towards its estimated natural rate of unemployment. A different perspective of the labor market shows that labor force participation is at its lowest level in nearly forty years. While we have seen a cyclical recovery in employment figures, the economy still faces secular headwinds from an aging population. Perhaps, there is more slack in the labor market than suggested by official employment statistics. If so, the failure of wage inflation to materialize could increase the risk of policy error by the Fed. How Healthy is the Labor Market? Labor Force Participation at Multi-Generational Lows (click to enlarge) Source: Bloomberg, Bureau of Labor & Statistics; (Data through 11/30/15) The weak economic recovery post-crisis has kept the U.S. economy from operating at its full potential. Limited investment by a necessarily more austere government after record cyclical deficits has pushed the average age of government fixed assets to its oldest age on record. Similarly, corporations have been more apt to invest in their own securities through record share buybacks than undertake capital investment in the real economy, extending the age of the private capital stock. Older fixed assets and infrastructure could be another structural headwind that pressures domestic economic growth. A Growth Drag from Aging Infrastructure? Source: Bureau of Economic Analysis 2015 was a fascinating year in financial markets. Plunging commodities, flagging Chinese growth, ultra-low rates in Europe, and the underperformance of higher risk investments in the United States all were symptomatic of tumultuous global markets. Domestically with equity multiples still above historical averages and yields on investment grade assets still historically low, forward returns are likely to fail to compensate investors for a continued heightened volatility. Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Nathan Buehler Positions For 2016: Attractive Opportunities In ETFs

You don’t have to trade every day to make above average returns in the market. Patience is the key to any good strategy. For typical ETFs that track broader indexes, watch the management fees when considering a fund. The Fed will continue to provide distractions throughout 2016 with constant assessment and analyses of when they will raise again and what that means for the economy. Welcome to the ETFs section of Seeking Alpha’s Positioning for 2016 series! This year we have once again asked experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction. Nathan Buehler has been an author on Seeking Alpha since May 2014, specializing in the coverage of ETFs and volatility investments. In addition to writing on Seeking Alpha, he works full time as a Teacher in the Lee County School District, volunteers as his communities HOA President, and participates in local government. Most of his strategy is geared towards long term outlook with focuses on short term events or situations that create attractive opportunities. Seeking Alpha’s Carolyn Pairitz recently spoke with Nathan to find out what he is expecting from ETFs in 2016. Carolyn Pairitz ((CP)): While you cover a number of ETF topics, the VIX has been your focus on Seeking Alpha. What drew you to study and invest in volatility? Nathan Buehler (NB): I started investing in penny stocks when I was a teenager. I had no idea what I was doing and lost most of the money I invested. I didn’t give up and was always looking for ways to get rich quick. Getting rich quick also led to additional losses. As I grew up and matured I began to realize there was an opportunity to make money off of people that were either looking to get rich quick or panicking. I started researching volatility as an asset class and began practicing with options strategies and trying to learn everything I could about how volatility behaves relative to the market. Eventually I fine-tuned my knowledge of the VIX to the point I felt comfortable trading it. I love investor psychology and I will often have different takes and points of view on the VIX than other seasoned investors. This again comes from the fact I am self-taught. I learn something new every day and use that to continuously improve upon my investment objectives. CP: Do you have any advice for readers considering ETFs for their portfolios in 2016? NB: For typical ETFs that track broader indexes, watch the management fees. There are a number of very low cost funds run by very reputable companies. For volatility ETFs my only advice is to fully educate yourself before trading these products. This is also true for many ETFs that track commodities and have very specific objectives. ETFs don’t always behave like a stock and can lead to serious losses if an investor is not properly prepared. CP: Going into 2015, which asset classes are you overweight? Which are you underweight? NB: In my general portfolio I have moved overweight in select oil companies. I believe this is a cyclical pattern and as long oil prices stay low, demand will keep increasing. Eventually economics will take over and the present fear factor will clear itself up. These are positions I plan on keeping for 5-10 years so even if oil takes another year to recover, I am fine with waiting. CP: The SEC recently proposed rules that could shake up the current structure of leveraged ETFs. Could you elaborate on this further and how it could affect the ETF market in 2016? NB: The ETF companies have been on top of this from the start and ProShares even contacted me directly in response to one of my articles that covered the topic. For right now it doesn’t appear that this rule will have a real effect on any of the 2x leverage ETFs. However, many if not all 3x leverage products could be forced to close. I am not a fan of 3x leverage products and I feel this is the right decision to protect investors from themselves. At some point it is wrong to let people purchase a product that could wipe out their entire net worth in one day. Gambling is still legal if someone wants to bet it all on black. CP: With the Fed having raised fund rates this December, are you updating you VIX strategy or do you feel this change was already priced into the market? NB: I felt that the rise in rates was long overdue and well expected by the market. I was hoping for a hold which would have created an excellent opportunity for a sharp increase in volatility. The Fed will continue to provide distractions throughout 2016 with constant assessment and analyses of when they will raise again and what that means for the economy. To me, the Fed is just a bunch of noise. They get people hopped up and will calm the markets down. They have been a good tool in respects to volatility. CP: Are there any global issues on the horizon that ETF investors should pay particular attention to? NB: Geopolitical events always provide good opportunities for volatility. Two years ago Russia was providing regular spikes in volatility. The world loves a villain. We make movies about them and the super heroes that save us. Russia and China used to be those villains in regards to the stock market. Investors loved to gawk over what Russia was doing, who they were invading, and how China’s economy was collapsing. Now we have ISIS. Friends and foes alike have come together to take on ISIS. As far as I am concerned, this is a negative for volatility, a positive for the market, and a win for humanity. CP: As a teacher and an author on Seeking Alpha, do you have any advice for readers who work a full time job but also want to be involved in the markets? NB: There have been multiple studies out on how teachers make the best investors. Each of these studies cited one fact consistently, lack of trading. You don’t have to trade every day to make above average returns in the market. I constantly get questions on timing the market, when to get in, when to get out, etc. Investors need to chill out. My goal is to make a 15% return during the calendar year. Not 15% in January and then try for 80% by December. Patience is the key to any good strategy and if you are glued to your monitor all day watching the ticks of the market it isn’t healthy. I would conclude that a full time job gives you proper time to analyze the markets in the evenings and make more rational decisions by the next trading day.

Integrating Water Risk Analysis Into Portfolio Management

By Monika Freyman, CFA My previous article, ” Liquidity Risks of the H2O Variety ,” explored growing investor awareness about water risks within their portfolios and how that awareness plays into their investment decision making. Here, I will examine some of the increasingly sophisticated approaches that investors can take to integrate water risks into portfolio management. My recent survey of 35 institutional investors’ water integration practices found that while many investors think their methods, tools, and databases need to improve and evolve, they also found it worthwhile to integrate water into their research processes. And no wonder. As population pressures create competition for water, global groundwater supplies are declining and climate variability is increasing – leading to longer droughts and more intense flood events. All these factors pose risks that are hard to ignore. Water risk analysis happens at different stages of investment decision making, from the initial asset allocation strategies, to portfolio level analysis, through to the buy/sell decision. For example, one pension fund brought together portfolio managers from different asset classes to study how different markets, investment instruments, and geographic regions are exposed to the global water crisis. A few investors were also consistently analyzing their portfolio’s water risk exposure or its water footprint. Although far from a perfect approach – often missing location specific data or wastewater production metrics – portfolio water footprinting can be helpful in flagging companies and sectors with high water risk exposure relative to a benchmark and highlighting where further analysis is warranted. Various forms of portfolio analysis and attribution software allow managers to run water use metrics versus an index. For an example of water footprinting, see this South African study . At the individual security level, investors identified three critical research steps to obtain a comprehensive picture of water risk exposure: Understand Corporate Water Dependency: This varies by sector and, of course, company, with some industries relying heavily on access to abundant freshwater suppliers directly or in their supply chain. Corporate water dependency is not always easy to assess, but some companies are making the task easier by reporting their water use and wastewater trend data more consistently on their websites, in their annual reports, SEC filings or to data aggregating organizations, such as CDP Worldwide’s Water Program . Combine Water Dependency Data with an Assessment of Water Security: This gives a more comprehensive picture of corporate water risk exposure. A company may have high water needs but have their operations located in relatively water abundant regions. Another company, however, may be operating in regions of high water competition and drought. Such assessments are not simple to perform, but evolving tools, such as World Resources Institute (WRI)’s Aqueduct corporate water risks map , the World Wildlife Fund (WWF)’s Water Risk Filter , and other efforts are seeking to make the task easier. Get a Sense of Corporate Water Risk Awareness and Response: This step is essential because a company may have high water needs and poor water security, but mitigate the risks very effectively by elevating water issues to strategic decision making and putting water management and reporting systems in place. Tools such as The Ceres Aqua Gauge can be used to assess how well companies are managing their water and their exposure to water risks. For a more comprehensive list of third-party water tools and analytics, An Investor Handbook for Water Risk Integration is a helpful resource. Once water risk analysis is conducted on a corporation or security, our research found that fund managers use this information in a variety of ways, from avoiding high water risk industries or companies, to influencing internally created company environment, social, and governance (ESG) scores, to clarifying corporate engagement priorities. Several managers use their corporate water risk assessments to influence or modify financial projections or their weighted average cost of capital assumptions. For example, one fund manager studying companies in Brazil conducted scenario analysis modeling regarding how much the market cap of companies would be impacted if they had to absorb more of the costs of treating their wastewater discharges, especially as drought intensified and communities and regulators were becoming less tolerant of water use and pollution. Once impacts to market cap were assessed and shared with the management of those companies, engagement on those issues was far more pointed and productive. Other managers were trying to get a deeper understanding of the probability of large financial losses due to strategic risks related to water, such as not being able to grow revenue, access new markets, or develop new facilities. No matter what methodology one chooses to deepen water risk analysis practices, the most critical things to keep in mind are that water risks can lead to unlimited financial impact and loss. If a company loses access to water, a community kicks them out of a region due to water concerns, or permission to discharge wastewater is denied, the financial and strategic implications can be immense. For example, Newmont Mining (NYSE: NEM ) has postponed a $5 billion project in Peru due to community concerns over its water practices. In addition, it is important to look at sector specific issues, as water risks related to mining are obviously very different to those in semi-conductor manufacturing and so on. An Investor Handbook for Water Risk Integration includes a sector-specific cheat sheet on these issues. And most important of all: No matter how incomplete your water risk analysis starts off, it will likely provide a better understanding of sector or company risks (and opportunities) – which ultimately should add predictive power to your existing research processes. The goal is not to be perfect in your methods from the outset, but to begin including water risk analysis into your portfolio management practices. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.