Microsoft, Alliance Data Among Picks for a Rising Rate Cycle

NEW YORK (TheStreet) - Investors should realize interest rates are going to rise sooner rather than later, and look to adjust their strategies accordingly, fund managers warn, pointing to sectors set to benefit from a recovering economy.

While Europe and Japan mull further stimulus, U.S. markets have slid sideways on uncertainty over economic growth as the Federal Reserve winds back bond purchases.

However, many strategists urge American investors not to reduce exposure to domestic stocks, noting equity returns are usually strong in the lead-up to the first rate hike after easing - expected early next year - then slow with each subsequent rise.

James Investment Research notes U.S. rate rises will stem from a return to more normal levels against a strengthening economic backdrop, after a period of abnormally low rates. Director of Research David James says investing in this environment is markedly different from one where rate rises are used to tame inflation. "The question is not so much when will rates rise, but what is the reason for it?" he said.

As such, he recommends small cap stocks - which have higher exposure to the domestic economy, along with cyclical and technology names. Small caps have underperformed the broader market year-to-date, amid concerns over valuations, after the Russell 2000, rallied 33% in 2013. Several fund managers note that small cap biotechs without cashflow have inflated the overall valuation of the index, with opportunity in other sectors. James acknowledged that small caps may not bounce until the anticipated improvement in second-half economic data - though investors may want to catch any bounce before it occurs.

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