City strategist thinks Lloyds is a winner

Investment strategist at deVere Group Tom Elliott explains why political necessity will make Lloyds a winner in 2016:

Why Lloyds is top tip for 2016

My favourite blue-chip share for 2016 is Lloyds Banking Group. It's had a miserable couple of weeks (as of 18 December) on fears that regulators will demand Lloyds store more capital on its balance sheet, which will shrink the amount of capital Lloyds can lend and gain profit on.

I think investors are underestimating the political will in the Treasury to see the government's stake in Lloyds - a lot of which it will be selling off in 2016 - sold at a reasonable price and as a successful investment. I think there will be political pressure on UK regulators to go easy on Lloyds. Sure, the assets on its balance sheet are dodgy as it's predominantly UK residential mortgages. In fact, the sole raison d'être of Lloyds seems to be to fuel house price inflation, which is not healthy.

But for 2016 I think it is going to be a winner, with a very healthy dividend, in part to ensure the government stake gets away. So hold on to what I think will be a bumpy ride for Lloyds over the next three/four years, but in the near-term should be a winner backed by political necessity.

Within the UK market, which sectors do you prefer?

Within the UK market there are two areas I like. The first is domestic-focussed UK banks because they have a good wind behind them with the strengthening UK economy and housing market - I'm excluding the ones that are Asia and Emerging Market oriented.

I like small-caps and they have had a good run, but bear in mind the sector is far more sensitive to UK growth. The large-cap, blue-chip, FTSE 100 index will continue to be weighed down by its exposure to oil, mining and emerging market-oriented banks. So, I think small-cap will have a good year in 2016.

Where will the FTSE 100 finish this year?

My prediction for the FTSE 100 is around 5,700, dragged down by the strong weighting still in oils and mining. I emphasise "still" because you'd have thought after the pull-back in oils and mining that it would be negligible, but it's not. I think that will dent confidence.

I'm also a bit nervous about bond proxies in general. If we do see the Bank of England raising rates and some of those proxies suffer as investors start buying UK Government debt in preference to shares, I would be rather nervous over utilities. I think a negative performance from the FTSE 100 is likely.

How investors can survive 2016 correction

I think there will be a major market correction in 2016, driven from two different sources: the US with a shallow recession, particularly given the high level of inventories we see in US companies and the almost grinding to a standstill of profit margins. We will also see more distressing news coming from emerging markets.

The key theme linking both is high US rates which is likely to push the dollar up.

My thinking is that US rates will be allowed to go up, almost irrespective of the effect on the stockmarket and, possibly, the economy. There are hawks in the Fed that see bubbles everywhere caused by years of very low interest rates and they don't think cheap money should ever have been allowed to feed into the high yield market. They want to let the bubble burst.

Once the market realises this mind-set is taking hold, I think we could be in for a period of substantial unease. What's really important is that the underlying economy doesn't lose too much ground. I think we can get away with just a shallow recession in the US.

What action should investors take?

I think the best thing investors can do to protect themselves from a volatile 2016 is to maintain a fully diversified portfolio by geography and assets. That means a wide range of fixed income, equity and alternatives, whether that is commercial property or more illiquid assets, although beware you can't sell these in a hurry.

"Within equities, I definitely prefer Eurozone ex-UK and Japan."Drilling down my preferences, in fixed income I do like global, A-rated and above, commercial paper and core government bonds. The German government is highly unlikely to default, for example.

If I wanted to pick up on yield within fixed income I would favour the Anglo-Saxon ones, perhaps Canada and Australia, where yields are a little more generous because of the weakness in commodity markets, which is a major source of income for those economies. But they are reliable creditors, along with the US Treasury and UK Gilt market.

Within equities, I definitely prefer Eurozone ex-UK and Japan. Both are undergoing wrenching structural reform programmes that will deliver long-term growth to their economies. They will also benefit from any strength of the dollar against the euro and the yen arising from higher US rates.

The UK I'm not very optimistic about, so will take an underweight position on UK stocks along with an underweight in US stockmarkets and Emerging Markets.

Hot sectors to watch in 2016

I think the major themes for capital markets in 2016 will be a concern that the Fed has moved too far too soon with its monetary tightening - I'm expecting a series of interest rate hikes that could risk taking the US into a shallow recession.

My second worry is that we will see the consequence of higher interest rates coming through as defaults across a wide range of high yield investments. This could be in the US junk bonds issued to the energy sector to finance the US shale boom.

"Keep a keen eye on commodities."I'm also thinking of private sector credit in the emerging markets, where a lot of the growth has been fuelled by households and companies taking on dollar denominated debt to expand. As rates go up, particularly as global investors refuse to roll over debt as it matures, unless the holders pay a much higher interest rate, I think we might see real distress.

Which sectors could make the headlines?

The sectors most likely to make the headlines in 2016 are corporate credit and high-yield, but there is a danger the distress in high-yield will feeds into investment grade. It's only really the A-rated and above that I would be interested in investing in in 2016.

Another area set for distressing headlines is commodities, particularly energy producers and mining. In many ways this is just a continuation of a multi-year theme, but we have begun to see some really strong announcements from the big miners, particularly Anglo American in terms of headcounts and closures. I think we will see more of that, but in that lies the seeds of the next cycle upwards as production is mothballed we should see a tightening of prices.

Keep a keen eye on commodities.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.