The Captain Has Turned on the Seatbelt Sign
Key Points Adapt to higher volatility Rising stock market volatility is a top concern of financial advisors for the second half of 2016, according to our mid-year survey (see Figure 2 for full list of top concerns).1 Therefore, we think investors should consider areas of the market that have historically been uncorrelated to stocks and bonds, such as gold, for potential risk mitigation when markets get turbulent.2 Look for income opportunities, but don’t stretch In a continuing low-yield environment, investors need to move a bit further out on the risk spectrum for income while avoiding potentially overcrowded, expensive areas of the market. We favor high yield corporate bonds, senior loans, preferred shares, convertible bonds and high-quality dividend stocks. Build a stronger core In a low-return world with heightened volatility, investors should ensure that they have a strong foundation. They should consider looking for better buy-and-hold core positions that seek to provide broad market exposure with active and smart-beta approaches. Then, they can get tactical with sectors and industries to potentially harness growth or business cycle trends (homebuilders and the resiliency of the consumer and housing markets), or seek out value opportunities from perceived mis-priced or inexpensive areas of the market (energy).

WHAT THE FLOWS ARE TELLING US
When looking at the ETF flows so far this year, two main trends immediately jump out: investors are moving into bonds and gold. Demand for these two areas reinforces a couple of themes we have already mentioned– namely, that investors are hungry for income in a low-yield environment, and they’re looking for diversification and potential risk mitigation in what has been a turbulent market so far in 2016. Fixed income ETFs are on pace for a record year (see  Figure 3), gathering about $44.4 billion so far in 2016 as  of June 15, compared with inflows of about $2.6 billion for equity ETFs, according to Bloomberg Finance L.P. The  pace of the fixed income ETF flows has been steady and strong, even when compared against recent years. We believe the heady flows to fixed income ETFs are being driven by  three main factors: • Investors seeking potential stability in bonds due to uncertainty over the US presidential election, central bank monetary policies, the uncertainty surrounding the Brexit vote and other question marks • Desire for any income in an environment where over $10 trillion of global government debt carries a negative yield3 • Allocating to ETFs for cost-efficient exposure to entire bond sectors and asset classes rather than trading individual bonds, which can raise liquidity and transaction-cost issues.
Meanwhile, the top-selling fund so far in 2016 is SPDR Gold Shares (GLD®) with net inflows of $10.1 billion, the best annual start ever for this ETF in terms of flows.4 The double digit increase in the spot price of gold this year reflects investor concerns over currency volatility and potentially higher inflation. Elsewhere in ETF flows, Figure 4 shows the top and bottom segments across some fixed income and equity categories. In equity sectors, a preference for utilities and the sell-off in health care shows investors are looking for stable, traditionally “safer” sectors rather than high-flying growth names that may also be affected by a contentious US Presidential election. Similarly, in corporate credit, investors are favoring investment grade over high yield as default rates have risen above 4 percent for the first time since 2010.5 In international equities, investors are favoring broader over more targeted exposures, such as last year’s fund flow darling: currency hedged ETFs.

Key Takeaways • Our base case for 2016 is that investors should be prepared for more of the “low and slow” growth that has characterized the global economy since the financial crisis. That means in equities, we believe investors should look for pockets of opportunities and growth.  • Outside the US, tilting to the Eurozone and Japan where the accommodative and pro-growth macro currents provide the strongest tailwinds is ideal.
• For the US, a resilient consumer and a potential Federal Reserve rate hike should continue to support and fuel top and bottom line growth in consumer related and financial sectors.  • In fixed income, still-low government bond yields and the desire for protection from potentially rising rates mean investors may have to explore more credit- sensitive sectors including high yield, senior loans and convertibles.
VOLATILITY IS HERE TO STAY
In our 2016 ETF & Investment Outlook, we cautioned investors to expect low growth and inflation, and to be ready  for elevated volatility with risks skewed to the downside.  About halfway through the year, we don’t see these headwinds dissipating in the near future. Volatility is here to stay as investors fret over the extended age of the current bull market, a lack of earnings growth, China, Europe, and perhaps most importantly, the most divisive US Presidential election in recent memory. That’s why in this uncertain market, we believe it makes sense to add historically uncorrelated real assets such as gold that could also provide some potential risk mitigation against unexpected events. Since August 2015, investors have been on a rollercoaster ride in US equity markets. The end result wasn’t too bad since the S&P 500® Index is little changed, but the journey was difficult (see Figure 5).
Now, the bull market is in its seventh year, and investors  are nervous about the apparent lack of catalysts, such as earnings growth, to fuel the next leg. There seems to be a glass-half-empty mindset as risks remain tilted to the downside, economic growth is subdued and still-low bond yields reflect a pessimistic outlook and demand for “safer” assets. Meanwhile, investors wonder how much more central banks can do to improve the picture.
2016 Mid-Year ETF & Investment Outlook
The challenging, back-and-forth action in the S&P 500 in  recent months shows how easily investors can get unnerved, with sentiment swinging between fear of an impending crash, to fear of missing the next rally. Quite simply, it’s a market that has confused bulls and bears. The CBOE Volatility Index (VIX), better known as Wall Street’s fear gauge, still resides at the low end of its recent range, despite a mini-spike in June, which suggests that overall, investors are leaning more toward complacency and are far from panicked. Yet the lesser-known CBOE SKEW Index, known by traders as the Black Swan Index, tells a different story. The SKEW, which is calculated from the prices of S&P 500 out-of-the-money options, is above 100, a level that suggests some investors are positioning for a tail risk event. A combination of a VIX oscillating between high and low periods, and an elevated SKEW Index, indicates that markets are not complacent, but on edge, and prone to bouts of volatility.
In this confused market that can quickly see sentiment swing to extremes, we believe investors should focus on diversifying riskier assets such as stocks and adding asset classes that may provide some potential risk mitigation, such as gold. Gold may reduce volatility by diversifying portfolios—a byproduct of its historically low correlation to most key asset classes, such as stocks, bonds and commodities. In fact, over the past 25 years, the correlation of gold to stocks, bonds and other commodities was -0.01, 0.19, and 0.44, respectively.*

Key Investor Takeaway We believe gold can play a strategic role in portfolios and provide some potential risk mitigation from extreme events such as a loss of confidence in central banks or a credit contagion in the Eurozone, for example.

GENERATING YIELD:  BACK TO BASICS IN FIXED INCOME
Investors are facing a very tough environment for building fixed-income portfolios that meet their basic needs of stability, income and diversification. Meanwhile, questions over global economic growth and future monetary policy make the current environment even more challenging. First, traditional exposures that worked so well during the three-decade bull market in bonds, such as the Barclays U.S. Aggregate Bond Index (the “Agg”), may not be good solutions going forward. The yield of the Agg, which tracks the performance of the US investment-grade bond market, has steadily declined to near all-time lows (see Figure 7).   At the same time, the duration (interest rate risk) has  increased significantly.
We believe the Agg and similar traditional exposures have  an unattractive payoff, leaving many investors with exposure  to more downside (elevated risk) than upside (generational  low yields). The Agg is also heavily concentrated in interestrate-sensitive sectors such as Treasuries, so it represents a  non-diversified, unattractive mix of low yield and high  duration risk. We believe investors should separate their portfolios into three distinct pieces – a Core, Complement and Cushion – that can address specific objectives and provide balance.  Investors can think of our Three C’s framework as a roadmap to construct a fixed income portfolio designed for today’s backdrop with the goal of providing income, diversification and stability. Core Intended to provide broad exposure to a diverse set of fixed income asset classes. Rather than traditional exposures like the Agg, investors can take an active approach to the core that mixes interest rate- and credit-sensitive sectors for diversification whether rates are rising or falling. Complement A satellite or tactical exposure that seeks to capture trends, income or enhance diversification around the core. In this income-challenged environment, we believe investors should look beyond traditional bond sectors. In this bucket, we favor credit sensitive sectors such as bank loans and high yield bonds for the income they may provide. Cushion One way to potentially cushion a portfolio against today’s uncertain environment is by seeking short term exposures with low absolute levels of risk and low correlations to traditional bond sectors. These exposures may provide stability and diversification, helping to mitigate volatility across the equity and fixed income sides of a portfolio.

As previously discussed, the traditional bond sectors in the fixed income marketplace provide very little yield for the amount of duration risk assumed. Ten years ago, the Agg carried a yield of 5.7 percent — now it is barely above 2 percent.  The shaded section of Figure 8 below contains the Agg’s main bond sub-sectors (Treasuries, Credit and Mortgages), all of which yield less than 4 percent. With a real need for income, investors may want to consider some of the areas “outside  the box.”
Beyond Bonds Outside of just focusing on fixed income, we believe investors may also want to consider high-quality dividend stocks, preferred shares and convertible securities, as an approach to help generate some yield in this current “low or no yield” world.
Generating Income  |  Key Investor Takeaways • Years of rock-bottom interest rates and ongoing uncertainty over monetary policy have made building bond portfolios that provide diversification, income, and stability an increasingly challenging task. • We prefer an actively managed core, supplemented by a complement for income and diversification, and a cushion for potential stability and risk mitigation. For the complement, we like senior loans or high yield bonds. For the cushion, we prefer floating rate notes, as they historically have a low duration6 (interest rate risk) but may be able to provide some yield, especially if the Federal Reserve does hike rates in 2016. • High-quality dividend stocks, preferred shares and convertible securities can also be considered to potentially generate income.

SURVIVING IN A LOW-RETURN ENVIRONMENT
Investors should be prepared for more muted rates of return from the main asset classes. Our Investment Solutions Group (ISG) at SSGA formulates asset class forecasts on a quarterly basis, and their latest projections underscore the low-return environment that investors must contend with (see Figure 9).7  In equities, the case can made that the performance of recent years was partly driven by expanding multiples and share buybacks, but now valuations seem to be at least full, and earnings growth appears to have peaked – S&P 500 companies have experienced four consecutive quarters of year-over-year earnings declines.8 In the US, the dividend yield on the S&P 500 was about 2.3 percent at the end of the first quarter, and we anticipate a real earnings growth rate of roughly 1.8 percent. Therefore, we forecast a real return of 4.1 percent for large cap US equities. Combining this with our long-term inflation forecast, we see long-term equity returns in the 6.1 percent range. This forecast incorporates the view that S&P 500 valuations are fairly consistent with historical averages, and that real earnings may grow at a pace slower than long-term historical averages. From an investment standpoint, muted expected returns in equities mean we believe investors need to get “more from their core” than simply buying the S&P 500 and other broad-based indices. One approach is using smart beta strategies in the core to seek out factors — such as low volatility, value, or quality — that have historically outperformed market-cap-weighted indices in the long term.9 With a diversified and well balanced core, investors can take a more tactical approach with sector and industry investing to potentially harness growth or business cycle trends (homebuilders and the resiliency of the consumer and housing markets), or seek out value opportunities from perceived mis-priced or inexpensive areas of the market (energy). Turning to bonds, in general at shorter horizons we anticipate limited returns given low initial yields and limited anticipated rise in rates. That’s why in previous sections we outlined an approach that favors active management at the core, supplanted by high-yielding fixed income classes to help generate a potential return.
Low-Return Environment  |  Key Investor Takeaways • Access potentially better buy-and-hold exposures, and consider multi-factor smart beta approaches to take advantage of the potential cost and transparency benefits of traditional cap weighted index strategies, but tilted towards other drivers that may add value over time.
• Employ a tactical approach with sector and industry investing to navigate market trends, and potentially take advantage of market inefficiencies by increasing or decreasing exposure to sectors and industries that may be rewarded based on their potential growth or perceived value.