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Some fund managers think the U.S. Federal Reserve Board won’t be able to raise rates as much as it has signalled because of the risk of pushing the U.S. economy into a recession.Courtney Crow/The Associated Press

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Interest rates are going up – there’s no denying it. The Bank of Canada and the U.S. Federal Reserve Board both raised their key rates for the first time since 2018 this month. The U.S. central bank is setting an even more hawkish tone, indicating it’s prepared to raise rates as many as six more times this year.

The question now is how this change in the interest rate trend will affect financial markets – and how investors should respond.

“As a general rule, asset values don’t win in inflationary times,” says Lyle Stein, president of Forvest Global Wealth Management Inc. in Toronto.

He notes that unless an asset has the ability to see its revenue stream increase faster than prices are rising, the asset’s value is likely to fall.

“The most important thing is to find assets with the ability to generate a rising income stream,” he says.

Mr. Stein says bonds, with their fixed payouts, fail the rising income test.

“In a rising [interest] rate environment, bonds are not fixed income, they are fixed loss,” he says. “Equities can offer a fighting chance, provided the company can raise prices in line with the price level and maintain margins.”

Mr. Stein feels commodity producers, especially in areas in which physical supply is tight, would tend to be winners. He adds real estate “could work,” provided rents rise faster than inflation, and banks could win if the interest rates they charge rise faster than what they pay to borrow.

When it comes to specific picks in the commodity space, Mr. Stein notes copper is in a very tight market environment that’s expected to get even tighter as demand for green power and electric vehicles takes off. He says Teck Resources Ltd. TECK-B-T is a way to participate in the sector.

In real estate, he notes the ability to raise rents is key and highlights BSR Real Estate Investment Trust HOM-UN-T, which owns non-rent-controlled apartments in Texas, as a possible choice.

“In financials, pick a bank,” he says. “They all can win. We’re more interested in exposure here than name-specific participation.”

How fast will interest rates rise?

However, some fund managers aren’t entirely convinced interest rates will rise as fast as most people are expecting.

“I think the market is assuming a rapid rise in rates, and I don’t think that’s necessarily going to happen,” says Paul Harris, partner and portfolio manager at Harris Douglas Asset Management Inc. in Toronto.

He feels the Fed won’t be able to raise rates as much as it has signalled because of the risk of pushing the U.S. economy into a recession.

Mr. Harris also notes that the traditional thing people would do in a rising interest rate environment is to invest in cyclical stocks like resource companies. However, he’s not a fan of these companies, calling them “terrible businesses” with bad balance sheets and inconsistent cash slows. Instead, he favours companies with good balance sheets and lower volatility – often found in the health care and consumer staples sectors.

In health care, he likes medical device company Stryker Corp. SYK-N. He notes procedures such as hip replacements and artificial knees were cut back during COVID-19, so there’s tremendous built-up demand. He also highlights Novo Nordisk A/S NVO-N, the world’s largest maker of insulin.

With financials, he picks Toronto-Dominion Bank TD-T and Royal Bank of Canada RY-T.

“They’ve become overcapitalized in the past few years, resulting in a real opportunity for significant share buybacks,” he says.

In consumer staples, Mr. Harris’s picks in Canada are retailers such as Loblaws Inc. L-T and Metro Inc. MRU-T, noting people still need to buy groceries regardless of inflation and interest rates.

Is it too late to buy?

Meanwhile, there are other diverging views when it comes to investing in a rising interest rate environment.

“I am going to be contrarian here,” says Barry Schwartz, executive vice president and chief investment officer at Baskin Wealth Management. “If you’re thinking about buying stocks that benefit from rising rates when everyone already knows rates are going up, you are too late.”

Mr. Schwartz feels the best beneficiaries of rising rates are Canadian banks and insurance companies, as well as companies that have large amounts of cash that can be invested on behalf of their customers and shareholders. Examples of the latter include Automatic Data Processing Inc. ADP-Q and Berkshire Hathaway Inc. BRK-B-N.

“Unfortunately, if you look at the returns of those stocks over the past 12 months, you already missed the party,” he says. “Everyone has been talking about rising rates for months, and those stocks have appreciated.”

Mr. Schwartz says that at this point, unless you think interest rates are going to rise much more than expected, it’s best to own companies that have pricing power or companies that can take market share at the expense of others.

He also notes that when interest rates rise, the economy could slow, which may lead to offsets to revenue and profits for banks and insurance companies.

Instead, Mr. Schwartz says to look at buying companies like Microsoft Corp. MSFT-Q and Apple Inc. AAPL-Q. He points out that they sell products that consumers and businesses cannot manage without and each has the ability to raise the price of its products and services each year.

He also likes companies that will gain market share like Costco Wholesale Corp. COST-Q, Waste Connections Inc. WCN-T and FirstService Corp. FSV-T. He notes these companies are growing, with lots of opportunities to build their businesses both in North America and internationally. Given their sizes, they will have the ability to manage rising expenses much better than their smaller competitors and be able to acquire struggling competitors at discount prices, he says.

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