A playbook for a post-stimulus world

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Ben Bernanke has handed investors a puzzle.

In signalling that he will be tapering the U.S. Federal Reserve's huge monetary stimulus, Mr. Bernanke opened the door to higher interest rates, which are expected to drag down corporate profits and weigh on stock prices.

But his move can also be interpreted as good news, indicating the world's most powerful central banker believes the economy is finally doing well enough, five years after the start of the financial crisis, to soldier on without the artificial help of the Fed's massive bond-buying program, which has been gobbling up $85-billion (U.S.) a month of U.S. Treasuries and mortgages.

Faced with two contradictory ways to read the announcement, investors have chosen to focus on the negatives. Since Mr. Bernanke's press conference on Wednesday, global stock markets have shed more than $1-trillion.

But as Douglas Porter, chief economist at BMO Nesbitt Burns, points out, Mr. Bernanke didn't actually say anything shocking. "The major reveal in the ... statement was that risks had diminished," he says. "Given that equity markets were at all-time highs in the U.S. and Germany recently, one doesn't have to be Fed chairman to come to that conclusion."

Markets may be looking further afield for their cues. A credit crunch in China has fuelled fears that the main engine of global growth in recent years is facing tougher times and is likely to reduce its voracious appetite for raw materials.

For investors, it's a new environment. For those looking for the ripest opportunities – or biggest dangers – consider this playbook for a post-stimulus world.

U.S. health care

The promise of higher interest rates on U.S. Treasuries, as well as stronger growth in the world's largest economy, is a powerful lure for investors around the world and is helping to drive up the greenback.

Combine the new attractiveness of the U.S. currency with persistent weakness in commodity prices as a result of worries about China, and Canadian investors have a compelling reason to shift away from their love affair with miners and energy companies, and look for U.S. stock deals amid the recent carnage.

The U.S. health care sector, for instance, is an industry that is well positioned to grow its bottom line because of an aging population, no matter what happens in China.

The U.S. Centres for Medicare and Medicaid Services found that elderly patients are more than twice as likely to be taking at least one prescription medication as people between 18 and 44. As more and more boomers retire, the demand for health services seems destined to grow.

To be sure, health care stocks are not risk free – government may impose new price controls – but an aging population will provide a reliable growth driver for the sector no matter what happens to the global economy.

Bonds

While stocks sometimes do fine in a rising interest rate environment, one thing is clear – higher rates are just plain bad for bonds.

Bond prices move inversely to interest rates, so as rates rise, prices fall. That is a reversal of what happened in recent years, as investors reaped near double-digit returns as interest rates fell to historical lows.

Now bond investors are experiencing the "puncturing of the complacency bubble," says Hank Cunningham, fixed income strategist at Odlum Brown Ltd.

His advice? Pare back on bonds and tilt more toward stocks compared to how you would invest in more normal times. If you do want to stay in bonds, Mr. Cunningham recommends investment-grade corporate bonds with a maturity of four or five years, which he advises holding until they mature, or for several years.

Mr. Cunningham suggests avoiding high yield bonds and emerging market bonds. These types of bonds were particularly hard-hit in this week's tumultuous markets, he notes.

Technology

Higher interest rates are a signal of economic strength, and better economic times usually entice businesses and consumers to spend more on technology services, software and devices.

The overall tech sector has trailed the broader market this year, but that could change at the first sign of tech orders increasing. Many major players, such as Apple and Microsoft, are flush with cash and won't become victims to higher borrowing costs. Instead they are well positioned to buy emerging rivals and return capital to shareholders.

While China's economic issues have become a drag on commodities and materials, the country is still fuelling demand for some technology. For instance, rapidly expanding wireless usage in China bodes well for Qualcomm Inc., ARM Holdings, Spreadtrum Communications and RF Micro Devices, says T. Michael Walkley, of Canaccord Genuity.

Mining

Miners are known for optimism even in bad times, but there is little for mining investors to look forward to in the months ahead.

Both gold and diversified mining company stocks have been hammered, with the S&P/TSX Global Mining Index having fallen by more than 30 per cent since the start of the year.

That trend is expected to continue as China's economy slows and the U.S. pulls back on its stimulus. The result is likely to be slower demand for both precious and industrial metals, which, on top of escalating costs, means lower profits for miners.

"I would avoid a lot in this space right now, because it's probably going to get worse," says John Stephenson, a portfolio manager with First Asset Investment Management.

The next opportunity could be more than a year away, after companies delay projects and cut production to restore balance between supply and demand. For now, Mr. Stephenson recommends investors stay away from junior miners, some of which may not survive the current market upheaval. Investors should consider only well-capitalized senior miners.

"I think what you're going to see is an unbelievable boom in companies like Teck Resources and Goldcorp, once the dust settles, but you're going to have to wait a long time."

Energy

For those wanting to bypass the materials sector but still looking for a resource fix, money managers recommend oil and natural gas stocks, depending on how tolerant an investor is of risk.

"I think oil stocks would be a lot safer. However, natural gas could be a wild card," says Michael Giordano, a portfolio manager with Stone Asset Management.

Demand for both commodities is expected to remain relatively steady in the years ahead, amid production restraints that will help to support prices.

In oil, Mr. Giordano prefers large-cap integrated companies such as Suncor Energy Inc. and Cenovus Energy Inc., and cautions against small-caps with less flexibility to manage potential price swings.

In natural gas, he points to Tourmaline Oil Corp. and Trilogy Energy Corp., both of which have large land positions and are exploring in the prolific natural gas regions in Alberta and B.C.

Jason Mayer, a portfolio manager at Sprott Asset Management, prefers natural gas plays to oil, believing natural gas prices will see greater percentage gains in the coming months.

"Your upside is a lot more pronounced with natural gas," says Mr. Mayer, whose stocks picks also include Tourmaline and Trilogy, as well as Paramount Resources Ltd. and Birchcliff Energy Ltd.

"The risk-return proposition is more robust with natural gas right now," he says.

Financial services

As markets tumbled Thursday, the few stocks to rise included insurers such as Manulife and Sun Life.

These companies can benefit from higher yields because it allows them to reap more income from the large amounts of bonds they buy.

The recent surge in bond yields, exemplified by the benchmark 10-year U.S. Treasury, which has rocketed to 2.5 per cent on Friday from around 1.6 per cent in early May, is actually good news for insurers.

For banks, the picture is less clear, because higher rates drive up loan defaults. For now, investors looking for a place to hide may want to consider insurers.

Brenda Bouw is a freelance writer in Vancouver. David Aston is a freelance writer in Toronto.