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Globe and Mail columnist David Berman.

The Globe and Mail

Central banks are unwinding extraordinary economic stimulus and investors couldn't be happier: Stocks are holding firm worldwide, reflecting optimism over the health of the global economy.

But what can investors expect if central banks continue to raise interest rates?

In Canada, the S&P/TSX composite index was up after the Bank of Canada raised its key interest rate by a quarter of a percentage point on Wednesday morning, as expected. Although the index closed slightly lower, ending the day at 15,143.99, down 5.15 points, financials, telecom and energy stocks rose.

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Elsewhere, market moves were noticeably stronger. The Dow Jones industrial average rose 123.1 points or 0.6 per cent, to 21,532.14 – a record high for the blue chip index – after Fed chair Janet Yellen testified before Congress that the strong U.S. economy can handle more rate hikes.

The Fed has already raised its key interest rate three times since December, most recently in mid-June.

In Europe, the Britain's FTSE 100 rose 1.2 per cent and Germany's DAX index rose 1.5 per cent, marking its biggest move in nearly three months.

The prospect of tighter monetary policy has hung over global stocks as a potential threat to corporate profits and lofty market valuations, but, so far, investors are embracing the upside: Higher interest rates coincide with rising economic confidence among central bankers, including the Bank of Canada.

"The decision to tighten monetary policy was backed by a more optimistic take on the economy as evidenced by an upgrade to Canada's 2017 real GDP growth to 2.8 per cent – the central bank expects a solid follow-up to the strong first half," economists at National Bank Financial said in a note.

The economists added that they expect another rate hike later this year.

The bond market is on-side with this assessment, given rising bond yields. The yield on the five-year Government of Canada bond is about 1.5 per cent, from below 1 per cent just a month ago.

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But where does this leave stocks? Despite Wednesday's modest rallies, the prospect of additional rate hikes could lead to some volatility as investors assess new data on economic activity and inflation.

Surprises in either direction could upset a delicate balance: Higher-than-expected interest rates could raise concerns about their impact on economic activity, while lower-than-expected rates could suggest that economic activity has already begun to wane.

Stretched stock valuations could also exert some influence. The price-to-earnings ratio for the S&P 500 is 21.6, close to its highest level since the bull market began in 2009, and well above levels seen prior to the financial crisis. The S&P/TSX composite index is slightly cheaper, but hardly cheap, with a P/E of 21.

While pricey indexes don't signal that a crash is imminent, they do raise questions about what will drive share prices higher – and rising interest rates are unlikely to help matters if they slow economic activity.

GMO, the respected Boston-based global asset manager, last month published its latest seven-year asset class forecast, showing that its expectations for U.S. large cap stocks is a dismal 4 per cent annual decline.

Nonetheless, rising interest rates are likely to create some winners even if turbulence picks up.

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In the United States, financials have shone within the S&P 500 since the start of November, when markets began to anticipate the Fed's first rate hike.

The sector has rallied 26 per cent, reflecting the idea that higher rates deliver fatter profits on bank loans and bigger yields on bonds held by insurance companies. That compares to gains of about 6 per cent for rate-sensitive utilities and real estate companies over the same period.

In Canada, bank stocks rose 0.4 per cent on Wednesday, led by Canadian Imperial Bank of Commerce's 0.9 per cent gain and National Bank of Canada's 0.7 per cent gain. However, insurance stocks retreated: Manulife Financial Corp. and Sun Life Financial Inc. fell 0.3 per cent each.

Rising interest rates mark an intriguing shift following nearly a decade of ultra-loose monetary policy that helped fuel a tremendous bull market in stocks. At the very least, expect a few bumps.

Stephen Poloz, governor of the Bank of Canada, and Carolyn Wilkins, senior deputy governor, give a press conference in which they announce the central bank's first rate hike since 2010.

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