Stocks for a Higher Interest Rate environment

Canadian stocks share much with the Toronto Blue Jays in that they pale in comparison to their US counterparts, proving once again just how much our economy relies on commodities, precious metals and energy.

Friday was yet another disappointing day weighed down by retreating gold stocks, fallout from Potash’s sub-par earnings report and questions about whether the Fed can exit QE-III without damaging the economy. On that latter point, traders will weigh in on the Fed’s policy meeting that will take place on Tuesday and Wednesday next week.

Analysts will search for any clues that might set a timeline for tapering, which is, at best, a forecasting exercise rooted in subtleties. In my mind, the market has already priced in some degree of tapering, as evidenced by the recent rise in mortgage rates around the world; the direct result of Fed Chairman Bernanke’s previous musings about how the Fed might exit QE-III. For the record, everything we have heard ex-post has been staged to placate financial markets, which ignited a sentiment driven rally that is just beginning to flicker.

On the whole I think the Fed has done a good job managing macro-economic volatility, and in the process has set up a scenario in which financial markets can perform despite higher rates, proving once again the long standing tenet that one should never bet against the Fed.

If you are into nuanced trading strategies, you will want to look closely at the US jobs data that will be released on Friday. There are wide ranging estimates as to the number of new jobs that were created in July. I am looking for a number around 170,000, although consensus seems to be at 185,000. If we get anything within that range, the US unemployment rate should fall to 7.5% down from 7.6% in June.

This number is relevant because employment is a factor in the tapering debate. The nuanced thesis is that a pickup in hiring – i.e. more than 250,000 new jobs – could shorten the timeline for tapering, whereas a slowdown in job creation – i.e. 100,000 print on the July numbers – could dampen any thoughts of the year end timeline. In my mind, neither scenario is likely, and even if it did come about, the Fed does not change policy on a single data point. Governors are more concerned about longer term trends.

Regardless of the actual number, I think the Fed will maintain its year end timeline which by the way, fits well with the appointment of the new Fed Chairman. It also meshes with another potential development in this Goldilocks scenario, which could come to light as early as Monday afternoon.

That’s when the US government releases its borrowing projections for the remainder of the year. If the US government requires less funding in light of a narrower deficit, that would imply smaller treasury issuance in the coming weeks, putting in place yet another factor that would allow the Fed to exit quantitative easing in a timely fashion.

The inference traders should draw is that rates will rise and QE-III will end, which means that you should focus on companies that will do better in a higher interest rate environment. Banks come to mind, as I have suggested in previous columns. So to do insurance companies, as witnessed by the recent strength in Manulife (TSX: MFC, Friday’s close: $18.30).

If you buy into the higher interest rate scenario then you might look at buying longer term calls on MFC. Specifically the January 18 calls at $1.25 or better look interesting.