RISK
The biggest issue for investors as we enter 2016 is defining the degree of risk one is prepared to take in the portfolio relative to what may be an environment where conventional stock and bond investments and weightings provide limited return. In one of our recent blogs we go into some specific thoughts and have spelled out our views as well in the opening paragraphs of this “Perspective”. You can read the
higher degree of uncertainty as you have gone through this piece. It does tend to push us toward hedged strategies, systematic trend followers and, where suitable, less liquid strategies. Yes, I know we are talking our own book. However, in my conversations with managers of more diversified portfolios there is a realization that less correlated strategies may do well this year. The exception, as discussed above, may be the credit markets away from commodities and energy both in the liquid and illiquid space. This year will require a more intense analysis of what is happening as we move through the next few months. The opportunities may become more apparent by mid-year. A mid-year rewrite may be a necessity.

Below are three wild cards, which, if nothing else could provide some good cocktail party conversation. One can’t put a high probability on occurrence or possible timing on any of these outcomes (certainly not the earthquake—hah, that may have gotten your attention). I have listed them in the order of probability. You can figure out whether I start with the highest or lowest.

INFLATION SURPRISES IN THE SECOND HALF OF 2016
The Fed’s inflation favorite, the core personal consumption expenditure (PCE) index, is only 1.3% yearover-year with the last number actually flat month-overmonth. If this number stays well below 2% odds are the Fed Funds rate will stay lower longer. There is a wild card to watch. It does relate to energy. But, one will point out, energy is not included in the core PCE calculation. That is true. However, the impact of a reduction in oil prices and energy in general doesn’t just affect consumers’ transportation and heating costs—putting more money in their pockets. It affects businesses as well, reducing both their energy and transportation costs and, in some businesses, the cost of hydrocarbon-based feedstock as a part of their product. When I hear, anecdotally, that a friend in the paint business is experiencing record profits because of a reduction in cost-of-hydrocarbonbased goods, transportation costs and maybe a bit of a lift in remodeling and new home construction, I can translate that into similar experiences in other industrial and commercial businesses. It does add to corporate profits. While it is difficult to make a precise calculation, the 50% reduction in oil and gas prices over the last year could easily have added $90-$135 billion to the more than $2 trillion in pre-tax corporate profits. That 4%-5% pickup in profits may have reduced the price increases that, otherwise, would have been needed to make up for part of the labor cost increases that were being incurred. That addition to profits will hold as long as energy prices stay flat. There will be a more modest additional lift to profits if prices stay at this even lower level. This will not be an every year increase to profits. Thus, if corporations want to show increasing profits this year they may have to look for price increases to offset the continued more than 2% annual increase in unit labor costs. If energy prices continue to stay around these levels or rise, the direct impact on the core PCE index won’t happen, but the indirect effect of having to absorb the increased labor costs without additional energy offset could start showing up in final price increases. Excess supply in certain industries could mitigate the ability for certain companies to raise prices, but by sometime in 2016—maybe mid-year—we could start to see more price increases. It will not happen across the board, but specific company and industry analysis could turn up some profit surprises, positive or negative, as the energy transfer of wealth dissipates. The Fed will notice.

THE ELECTION RESULTS DO CHANGE THE PARTY IN POWER EVEN THOUGH THE POPULAR VOTE IS PROBLEMATIC
As the Republican Convention in mid-July approaches it becomes evident there will be no clear candidate with the votes to be named on the first or second ballot at the convention. It also becomes clear that without winning Ohio and Florida it is extremely unlikely that a Republican ticket can win the presidential election. Even then the party will have to pick up an additional 13 electoral votes from states the party failed to win in 2012. After a rather contentious convention, the party selects as their nominees the two candidates whom they believe have the highest odds of winning those two states. In the national election the Republican slate captures enough electoral votes to win. It is a close vote in which the Democratic slate actually wins the popular vote given the overwhelming majorities in New York and California. Much can happen between now and mid-July that changes this outcome. This is an unusual election.

AN EARTHQUAKE ON THE RECENTLY DISCOVERED CUSHING FAULT CAUSES MAJOR DAMAGE AND THROWS US OIL MARKETS INTO TURMOIL
I don’t want to go the route of Iben Browning, forecasting an earthquake in late 1990 on the New Madrid fault that has yet to occur. However, we are seeing daily tremors in Oklahoma in the vicinity of the Cushing storage facility and pipeline system. In 2015 Oklahoma had more quakes of 3.0 or higher than any other state. Yes, that includes California. Some recent studies have identified a fault, named the Cushing fault, in the region where there is increased risk of a major earthquake in part from the introduction of ground water from fracking activity and tertiary recovery. I don’t know enough to make the mistake Iben did of putting a date on when an earthquake could occur, but if there is a disruption of the storage and pipeline systems in Cushing, for whatever reason at whatever time, it could push up the prices of refined product from shortages of crude and possibly lower further the price of crude as producers struggle to find storage and other shipment means for what they are producing. Gulf Coast refiners will likely bid up crude prices to keep the refineries going, but producers will need to move what they are producing by any means possible. It will be an interesting tug of war between the domestic producers and the refiners re who is in the best position to bargain. In the meantime offshore producers will step in to deliver oil to the Gulf Coast refiners who account for close to half of the production in the US.

This is just one of many possible tail risk disruptions to the supply of crude into the market place. It may be the most unlikely one. However, spending a few basis points on tail risks in a portfolio related to oil and distillate prices may prove to be a good investment.