Investors will hunt for income in 2016

Last week I did the easy bit, looking back at 2015 and investing through the rear-view mirror. This week, I’m going to look forward to 2016, swapping hindsight for a crystal ball. This is more interesting, of course, but a great deal trickier.

We spent most of 2015 worrying about when interest rates would start to rise. Now they have, the key question has changed. What we need to know now is how quickly rates will normalise, the trajectory of lift-off and where they will ultimately end up. The Fed and the markets clearly disagree on this, with investors taking a much more cautious view than the rate-setters. I think the markets will be proved right and Janet Yellen will take her time.

That will provide a support to equities, which remains my asset class of choice in the autumn of this seven-year-old bull market. Shares tend to do reasonably well in the early stages of an interest rate tightening cycle. It’s only later on when rates are rising to counter higher inflation that markets wobble.

Markets want to know when the Bank of England, headed by Mark Carney, will follow the US in hiking interest rates

As the European economy is probably in better shape than it looks, one of the big risks next year might be that monetary policy does not diverge as much as expected. The conventional wisdom is that the dollar will strengthen, putting further pressure on the euro, emerging markets and commodities. But that story may have run its course. A rising dollar would anyway be self-regulating, squeezing US corporate profits and so taking the pressure off the Fed to raise rates any further.

Not that I am yet ready to take the contrarian plunge back into oil, metals and the developing markets that depend on them.

The mismatch between supply and demand in the oil market in particular is only going to get worse in 2016, especially if the United States restarts energy exports and sanctions are lifted on Iran. Metals prices will not improve until the miners take meaningful capacity out of the market. That, however, still looks some way off. Commodities and emerging markets will be the next big value opportunity for investors, but that may not come in 2016.

This means that inflation will remain subdued throughout next year. I say this with some trepidation, because history is littered with occasions when inflation looked to be licked, only to kick in again surprisingly quickly. But I just do not see it happening in the absence of a rapid rebound in the oil price.

Low inflation and interest rates mean that the search for income will persist in 2016, which lays the groundwork for another good year for commercial property. Real estate looks cheap (outside the prime areas), yields on property are high and they are likely to rise further on the back of robust rental growth.

Cheap oil could keep boosting firms and families who consume the raw material  Photo: AP

The major asset class I am most worried about is fixed income, and not because of rising interest rates, although these will not help. The bigger concerns are credit quality, as companies have geared up their balance sheets in an environment of super-cheap money, and poor liquidity in a bond market no longer well-served by the investment banks.

If there is a move to the exits, investors could find them crowded. Hopefully, the yield cushion on high-yield and even investment-grade corporate bonds is comfortable enough to keep investors interested next year, but it is my biggest concern.

I am neutral on the world’s biggest equity market. The US cannot expect much of an upward re-rating from here, and earnings will struggle to pick up the baton with margins at historically high levels already. But there are enough positives not to call time on Wall Street just yet.

The American consumer has saved the benefit of cheap oil so far, but could start spending again next year, and the US remains a great hunting ground for those innovative technology stocks that are forming the market’s increasingly narrow leadership.

Elsewhere, I expect Japan to have another good year. Despite its strong performance in 2015, the Tokyo market remains a discretionary asset class for many global investors. For the first time in a generation, Japan looks like it could be emerging from its deflationary slump, earnings are rising and valuations reasonable.

Closer to home, the UK’s three-year sideways crawl could continue. Heavy commodity exposure and the shadow of a possible British exit from the European Union will weigh on sentiment next year.

The good news, however, is that both of those will keep a lid on UK interest rates. I do not expect a rate rise until 2017.