Unless we get a major crash, 2016 will be a year of rising dollar interest rates. And that means it will be a tough year for income investors.

Of course, if we do end up witnessing a crash, it’ll be an even tougher one.

Inflation seems likely to tick up, corporate profits will be nothing special, and high-yield bonds are clearly going to see a shakeout.

[ad#Google Adsense 336×280-IA]For income investors, the best bet may be to look outside the United States, as the dollar should tend to decline while European rates remain low and their economies strengthen.

European income stocks, in particular, should be a solid bet on both income and capital grounds.

Doves on the Loose
Fed Chair Janet Yellen and the Federal Open Market Committee (FOMC) raised its target range for the Federal Funds rate to 0.25%-0.50% on December 16.

The majority of the committee saw about four interest rate rises in 2016, taking the target to 1.25-1.50%.

I think that’s the most we’re likely to see. After all, in 2015 the FOMC was set to raise rates in June and again in September, but didn’t follow through because of adverse economic or market conditions.

In general, the FOMC is dominated by “doves” who favor low interest rates.

That’s not surprising, since almost all of them have been appointed during the period since 2008, when the federal funds target has been close to zero and the U.S. has had an administration that itself tends to favor “soft” monetary and fiscal policies.

Thus, I think the FOMC will find enough excuses not to raise rates during 2016 that the median expectation must be for two or three rate hikes at most, with a modest chance that the economy goes wrong and rates again fall to zero (or even below zero) by year-end.

Capital Losses for Income Investors
The worst losses will be on very long bonds of high quality – 30-year Treasuries.

It’s likely that 30-year Treasury rates won’t rise as much as short-term rates, but even a modest rise in their yields will have a disproportionate effect on their price – a rise from 3% to 3.5% in 30-year Treasury yields produces a capital loss of 9.2%.

The effect will be less on prime corporate bonds, but it will still be significant – especially if, as I expect, inflation ticks up. With falling oil prices dropping out of the year-to-year comparison and wages becoming stronger in an era of low unemployment, it’s likely to do so.

However, it’s unlikely that the rate rise will significantly affect the value of dividend stocks.

High-Yield Headache
A stock paying a 5% dividend is affected by corporate earnings and the expected safety of the dividend far more than by a modest rise in interest rates, which are still well below nearly all dividend yields.

Plus, rising inflation will also bring hopes of rising dividends (except on financial sector stocks). However, there are two factors that will affect the value of U.S. dividend stocks.

One is that earnings are unlikely to show strength. U.S. corporate profits have been running at record levels in recent years because debt financing costs have been so low (so the return on equity has been artificially boosted).

With rising interest rates, profits will inevitably be weak.

Second is the behavior of the junk bond market. Here the ultra-low interest rates of the last several years have caused an explosion of activity, with leveraged merger and buyout transactions, financed by junk debt, setting records.

This is now going sour.

The implosion of the junk bond fund Third Avenue Capital is a significant harbinger, much like the collapse of two Bear Stearns hedge funds invested in housing derivatives in August 2007.

It took over a year for the collapse of the Bear Stearns funds to lead to the collapse of Lehman Brothers, but it was a sure signal to those who know the markets.

Similarly, Third Avenue Capital’s collapse will lead to a meltdown in the junk bond markets, although probably not until September or October 2016.

That will cause a dip in high-quality corporate bonds and a sell-off in the stock market, but hopefully not a situation like 2008-09, in which seven million U.S. workers lost their jobs in a matter of months.

Where in the World Is Income?
Income investors would thus do well to have a substantial portion of their assets outside the United States.

Some can certainly be in Europe. The economy there is picking up a little, and there’s no sign of the eurozone raising interest rates.

The euro has been very weak this year, so it will probably strengthen against the dollar next year. In the meantime, the yield differential between the currencies remains modest while the eurozone continues to beat the United States in export markets.

Another option is to buy shares (but not bonds) in the better emerging markets.

Latin American economic management is improving, with the new Argentine President Mauricio Macri freeing the peso exchange rate on December 16. As in Europe, investors in emerging markets may find currency gains accompanying their income, as those currencies bounce back from their falls this year.

Finally, we should avoid Japan, which has a huge debt problem of its own.

Income investors will find it tough to make money in 2016, but we can achieve better results by spreading our risks across the globe.

Good investing,

Martin Hutchinson

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Source: Wall Street Daily