How to play market volatility

The unusually turbulent start to trading in 2016 has set the tone for what is likely to be another volatile year. A halt to trading in onshore Chinese shares, rising tensions between Saudi Arabia and Iran and the slowest U.S. manufacturing data since 2009 have overshadowed more positive data from the euro zone.

Investors will need to remain vigilant for signs of deterioration in the prospects for global markets, with credit spreads, global economic indicators, the Chinese renminbi and the Middle East in particular focus. But for now, the fundamental situation has not altered enough to warrant a change in investment positioning.

Confused businessman
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In China, the 7-percent slump in onshore equities appears to have been led by technical factors, as government efforts to prop up the market in the summer of 2015 lapse. In particular, a rule preventing investors who hold more than 5 percent of a company's free-float stock from selling is scheduled to expire on Friday, having been in place since mid-2015. This may have driven some retail investors to sell stock now, ahead of possible larger institutional sell orders later in the week.

Mixed economic data may have also contributed to the poor sentiment. The Caixin manufacturing purchasing managers' index (PMI) fell below expectations, signaling the 10th consecutive month of contraction. Still, the data did not mark a significant deterioration, and the services PMI pointed to the highest level of activity since April 2014. Other measures, such as retail sales, remain robust.

The soft tone was reinforced by U.S. economic data that showed the manufacturing sector slowing to its weakest pace since 2009. That said, the details of the report were more favorable, with production and new orders components both edging up. In the euro zone, Markit's manufacturing PMI hit its highest level since April 2014, with every country in the zone registering rising output and job creation in December.

At a global level, service sectors continue to perform well, while manufacturing remains troubled. China's growth is slowing, but it is transitioning toward a consumer-led economy. Growth in the developed markets is uninspiring but positive. The sharp decline in oil prices is creating dislocations in some credit markets, but ultimately should benefit consumers. Emerging markets remain beset by political concerns and issues with their cost of financing, but the malaise is not translating into crisis.

However, we clearly acknowledge that the market's assessment of potential downside risks, most particularly with respect to China, has changed. Consequently, the price the market is willing to pay for future earnings has, for now, fallen.

A key transmission mechanism between market uncertainty and fundamental economic factors is the change in credit market pricing. Weakness in oil markets is leading to higher credit spreads for energy-linked companies. There are signs — in the U.S. in particular — that this could spread beyond the energy sector. And disappointments in growth or policy accommodation in China could lead to a higher pace of debt defaults and restructuring across global emerging markets.

In our base case, we expect an only modest rise in U.S. high yield defaults, and we believe that markets provide sufficient compensation for downside risks, while in the euro zone, accommodative European Central Bank policy should keep credit conditions favorable. We remain overweight in European high yield credit on a six-month view. However, we will watch for signs that higher corporate borrowing costs, in both developed and emerging markets, are having a lasting negative impact on growth.

Another key concern is the Chinese renminbi. In our base case, we expect it to weaken, but only modestly, toward 6.80 against the U.S. dollar in 12 months. In this scenario, we do not believe that the yuan would act as a major driver for financial markets. However, a key risk to this view is the possibility that a disorderly depreciation of the Chinese renminbi, or uncertainty over its management, drives greater regional currency volatility and global deflationary pressure.

With respect to the Middle East, we do not believe this latest rise in tensions between Saudi Arabia and Iran is sufficiently severe to alter the outlook for global oil markets in 2016. That said, investors will need to continue to monitor the situation in case of a more serious deterioration in relations.

Overall, we are keeping our positioning unchanged and believe that global growth will ultimately support current valuations, and even an additional appreciation of riskier assets. However, further deterioration in credit spreads, currency moves in China, and developments in the Middle East are areas where we see a heightened need to monitor for risks.

Commentary by Mark Haefele, global chief investment officer at UBS Wealth Management, overseeing the investment strategy for $2 trillion in invested assets. Follow UBS on Twitter @UBSamericas.

For the latest commentary on the markets in the U.S. and around the world, follow @cnbcopinion on Twitter.