Comment: Investors must avoid being carried away

The UK has put in a more sedate performance with a gain of some 10 per cent, but markedly ahead given all the apprehensions prevailing at the end of 2012.

So it is not surprising that stockbrokers and fund managers have fired off a fusillade of optimistic predictions for 2014. . Some were even predicting a pre-Christmas rally to bring the year to a triumphant close. The opposite (so far) has proved true, with both the US and UK suffering losing streaks.

This does not automatically mean the coming year will be a poor one for the stock market. But we need to be alive to the risks that lie ahead in 2014. Arguably the biggest is a rise in interest rates and the fact that few mainstream forecasters are allowing for this possibility does not allay my concerns: most have already brought forward their expectations of a rise from 2016-17 to early 2015.

If the economy continues to improve, unemployment will fall towards Bank of England governor Mark Carney’s 7 per cent “trigger” level for a change in rates. Pressure would be compounded by inflation concerns as strengthening domestic demand works to drive prices higher.

Andrew Wells, head of fixed income at Fidelity, says the UK could be the first major economy to raise rates and that a hike could come as soon as next year. Investors need to begin thinking about how to protect their portfolios against this eventuality.

Although inflation dipped to 2.2 per cent last month, it has been running at 2.7 per cent for much of 2013, significantly higher than the US rate of 1 per cent and Europe’s 0.9 per cent. Fidelity portfolios are moving more into high yield and lessening their exposure to investment grade credit and government bonds. In a rising interest rate environment, UK gilts and investment grade bond funds would be hard hit. Investors would struggle to avoid the turbulence that such a change would bring, other than opting for ultra-safe fixed-interest holdings, index-linked bonds and cash.

Among funds recommended for managing interest rate risk are Old Mutual Global Strategic Bond, Royal London Sterling Extra Yield Bond and Invesco Perpetual Tactical Bond.

Moves towards higher rates are likely to dominate investor, as the US Federal Reserve is likely to begin the long-awaited tapering of its quantitative easing (QE) programme. Handling this without sparking a stock market sell-off presents a formidable challenge, but a big concern will be the impact on emerging market economies, particularly Brazil, India, Indonesia, South Africa and Turkey.

This brings me to one market which could well buck the trend – and rather counterintuitively given its barnstorming performance over the past year: Japan. But the factor that has accounted for the Tokyo market’s stellar performance is set to remain in place in 2014: money printing. Prime minister Shinzo Abe’s new economic policy, nicknamed “Abenomics”, is founded on a combination of massive money printing, higher government spending and attempts to free up the Japanese labour market.

The policy has worked to lower the yen and to raise the rate of inflation – positive here in the wake of long periods of deflation. And it has also kick-started an improvement in the country’s labour market: the number of job offers per applicant is at a five-year high, according to BlackRock.

The signs are that policymakers are determined to ensure that Abenomics doesn’t peter out in the manner of so many fiscal stimulus packages over the past 20 years.