If there’s one overriding outlook for the financial markets in 2016 it’s this: No big gains are expected. Which is too bad, since U.S. stocks and bonds are poised to end this year slightly lower while commodities are saddled with enormous losses, especially in the energy sector.
The weakness in oil markets is expected to continue though prices could hit bottom at some point, and the dollar is expected to remain strong though not quite as strong as it’s been relative to other major currencies.
Most important, the change in U.S. monetary policy, following the Federal Reserve’s first rate hike in almost 10 years, will color market performance not only in the U.S. but globally.
Given this backdrop, investors and advisors need to choose carefully for 2016, then monitor investments closely.
Here are the six best investment themes and picks for 2016 that ThinkAdvisor has culled from myriad outlooks by market strategists as well as interviews with strategists and analysts.
1. Buy Into QE — Favor Japanese & European Stocks Over U.S. Equities
Less than three months after the Fed slashed interest rates to near zero and adopted a massive asset buying program in December 2008, U.S. stocks hit bottom, then rose almost steadily, more than tripling in price by mid-May of this year, before retreating slightly. Now the central banks in Europe and Japan have adopted similar easy monetary policies, using quantitative easing and near zero or negative rates to boost economic growth, which is also expected to buoy stock prices.
“We think this divergence in monetary policy will be broadly a tailwind to European and Japanese assets, while acting as a headwind to U.S. (and potential U.K.),” write Goldman Sachs strategists in the firm’s 2016 Global Opportunity Asset Locator (GOAL) report.
That divergence could potentially widen as the Fed raises rates several times in 2016 while the European Central Bank and Bank of Japan stick with zero to negative rates and asset purchase programs. The BOJ recently expanded its QE program extending the maturity of the government bonds it purchases and increasing stock ETF purchases.
Goldman Sachs is overweight both European and Japanese stock markets – Europe because of “resilient growth, accommodative policy and a weaker euro” and Japan because “margin expansion and top-line growth will drive strong earnings growth and double-digit returns.”
Bank of America strategists, however, expect that European stocks will return just 0% to 5% on a total return basis in 2016 compared with 11% to 14% for Japanese stocks and 6% to 8% for U.S. stocks.
2. Hedge Foreign Currency Exposure
The divergence in central bank policies will continue to play out in the currency markets, where the U.S. dollar is expected to remain strong relative to other currencies, though possibly not as strong as it has been.
Still, U.S. investors owning foreign assets could forfeit some of their gains because of the currency translation. Investors should “take currency risk more seriously,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman. “Returns could be eroded by dollar appreciation.”
Hedging foreign currency exposure can reduce those risks. The currency-hedged iShares MSCI Germany ETF, HEWG, is up 6.05% through Dec. 21, for example, while the unhedged version of that ETF, EWG, is down 2.5%. That’s a differential of more than eight percentage points.
There can be costs to hedging strategies, but that’s inconsequential or nonexistent if the interest rate associated with the foreign asset is lower than the interest rate of an investor’s home country, which is the case now for U.S. investors purchasing European or Japanese stocks or bonds, but not stocks trading in Brazil, where rates now top 14%.
3. Favor U.S. Large-Cap Stocks Over Small- and Mid-Cap
During an aging economic cycle, like the one we’re experiencing now, large-cap stocks tend to outperform small and mid-cap stocks over the six months and 12 months following a Fed rate increase, according to LPL’s 2016 outlook.
That’s not surprising since, according to Goldman, large-cap companies have greater access to capital when rates are rising.
In the U.S. stock market, Goldman favors large-cap stocks with strong balance sheets, a high level of U.S. sales and rising profit margins. The investment bank especially favors mega-cap stocks in the S&P 100 over the broader large-cap S&P 500 index.
4. Own Tech and Biotech
Technology is the only sector showing “notable outperformance” relative to the broad market during the six months following a Fed rate hike and tech continues to show strength one year after the first hike, according to LPL.
“We believe technology will prove resilient in the face of rate hikes once again,” supported by earnings potential, and increased spending on technology by companies trying to remain competitive in their own markets, LPL strategists write.
Biotech, which straddles the tech and health care sectors, is another favorite among strategists for 2016. S&P Capital IQ expects a 21% increase in earnings for the biotech industry, which is currently trading at 14 times 2016 forward earnings — a discount to the 16 times forward earnings forecast for the broader S&P 500 index, according to Sam Stovall, managing director of U.S. equity strategy at S&P Capital IQ.
5. Buy a House or Homebuilder stocks
Now is an opportune time to buy a home, especially for those who want to lock in what will likely be the lowest rate on a fixed-rate mortgage for years to come.
Those rates haven’t increased yet, but they eventually will unless the Fed reverses policy, which is not expected. The Fed’s new rate-rising regime will initially will boost only short-term rates, affecting just variable rate mortgages, but eventually rates will reset on long-term fixed rate mortgages. (The 30-year fixed rate mortgage prices off of the 10-year Treasury note.) CoreLogic, a global real estate information and data analysis company, forecasts a 0.50% increase in the average 30-year fixed rate mortgage to 4.5% by the end of 2016.
“Knowing that rates will rise will help push people off of that straddling position,” says Stovall. “At least early on that could be constructive for homebuilding stocks.” The last time the Fed embarked on a new, tighter rate regime, in 2004, homebuilding stocks rallied 33%, followed by 25% gain the following year, says Stovall.
6. Manage Volatility
Many market strategists expect market volatility will rise in 2016, which, as always, poses a challenge for investors. The market could be “more volatile in the first half of next year than this entire year,” says Nick Colas, chief market strategist at ConvergEx Group. He says volatility will reflect a “confluence” of different factors: Fed policy and uncertainties around that, the state of the European economy and effectiveness of QE, the dollar’s strength and living in a “more uncertain and dangerous world.” The impact is “not good for risk assets,” says Colas.
Investors can manage increased volatility in several ways. They can own bonds or bond funds to offset the volatility in stocks or buy the VIX, the Chicago Board Options Exchange Volatility Index, which reflects a market estimate of future volatility. Or they can increase their cash holdings. That won’t keep up with inflation but it can reduce the risk of losses and provide investors the ability or investors to buy certain assets when the time is right. Holding cash, for example, allows investors to buy bonds as rates rise in order to earn additional yield, or buy to stocks on a market dip, just before the expected rally.
Colas suggests that investors worried about volatility increase their allocation to cash, as follows: If they typically hold 3% to 5% of their assets in cash, he suggests 10%. “The VIX is an imperfect thing to buy,” he says. “The ETF resets every day.”
— Related on ThinkAdvisor: