New risks abound as 2016 is shaping up to be an extremely volatile year at least. The key risks for 2016 stem from two factors:

• Sharp drop in energy prices that persists.

• Fed starting to raise rates.

Energy markets experienced historic declines in 2015. The main issue is not the oil price per se, but the way it impacts corporate borrowers and sovereign wealth funds abroad.

Energy & Corporate Credit

The effect on corporate borrowers in the US is evident in the pain felt throughout the high yield market. Junk spreads are going through the roof and are reaching pre-2008 levels. Merrill Lynch CCC or Lower Index has reached 16.7%, a level last seen right before Lehman Collapse. Increase in junk credit spreads leads to two very dangerous outcomes. One is the ncrease in corporate defaults, which will ripple through the books of various yield-hungry institutional and retail investors, who gobbled up junk credit to increase yield in zero interest rate environment. Global corporate defaults in 2015 were the highest at 212 since 2009, which is signaling a turning of the credit cycle. Defaults will be putting pressure on the markets in a number of ways. Many pension plans and other institutional investors such as hedge funds own corporate loans and bonds from these borrowers. This will lead to losses in institutional portfolios with possible liquidation of other assets as a contagion effect. As Jeff Gundlach put it, ‘The real question is how many hedge funds go bankrupt.

Liquid financial vehicles such as ETFs will also certainly be forced to liquidate other parts of their book to cover outflows that will result. As Bill Gross noted, no financial vehicle can offer greater liquidity than the underlying assets. Daily liquidity of high yield ETFs is a myth, since underlying assets are illiquid.

Energy and Petrodollar Recycling

During happy days of high energy prices, most of the revenues that emerging economies such as Brazil and Russia received was recycled back into developed markets via sovereign wealth funds and other vehicles. Barclays estimated that energy exporters bought about $3.1 trillion of bonds and stocks between 2010-2014. These days are over. Energy exporters are grappling with severe recessions, devaluations of currency. Will they puke up the $3.1 trillion of assets they accumulated? You bet they will.

Fed Rate Increase

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