Which stock markets are most sensitive to rising US bond yields?

The Federal Reserve recently indicated it will start reducing the pace of its monthly bond purchases and half of the members of its Open Market Committee now expect to raise interest rates in 2022.

This has made some investors nervous as tighter monetary conditions could result in substantially higher US bond yields and potentially lower equity valuations.

The 10-year US Treasury yield is the global benchmark discount rate frequently used to calculate the present value of future cash flows of financial assets. So, most equity markets will exhibit some sensitivity to changes in this rate.

However, not all markets are likely to respond in the same way. Some regions and sectors stand to benefit from rising bond yields, while others could lose out.    

Investors who have the flexibility to tactically adjust their global asset allocation should take note of these differences.

Not all yield rises are equal

Bond yields can be approximately decomposed into a real (inflation-adjusted) interest rate and expected inflation. Each component can influence the direction of stock prices in different ways. This is illustrated in Figure 1.   

For example, over the past 10 years, an increase in inflation expectations, as measured by the yield difference between nominal and real US 10-year Treasuries, has been on average associated with strong emerging market equity outperformance versus the rest of the world (i.e. MSCI All-Country World Index).

This should be intuitive, as low and rising US inflation tends to reflect improving global growth prospects, which are typically supportive for export-oriented regions such as EM.

However, if higher yields are driven by real rates, it could foreshadow tighter monetary policy and lead to higher borrowing costs. This would tend to hurt EM companies because many borrow in US dollars.   

In contrast, value stocks tend to outperform the most when real yields are rising, while growth stocks tend to underperform.

This happens because value stocks are generally shorter “duration” and therefore less sensitive to changes in real yields compared to growth stocks.

This is because the expected cash flows of growth stocks extend further into the future, so are more vulnerable to changes in the discount rate used to calculate their present value.  

Although it is worth highlighting that the experience of the past 10 years looks like an outlier compared to the long-term history and therefore cannot be guaranteed to continue (see our previous research).

Global small caps, European equities and UK equities tend to outperform regardless of whether rising yields are a function of expected inflation or real rates, but the magnitude varies.   

Rising yields tend to be most positive for cyclicals

The prospect of higher bond yields also has implications for different industry groups.

Cyclical industries generally outperform the broader market when economic growth strengthens and yields rise, while defensive industries outperform when economic growth weakens and yields fall.

This pattern can be observed in Figure 2. For example, banks, energy and materials have historically outperformed when yields have increased.

Our further analysis has found that most industries also carry similar directional sensitivities to both inflation and real rates. 

Selective equity exposure is key going forward

The Fed’s hawkish shift in tone signals a potential reversal in the benign combination of low real rates and higher inflation breakevens that has been so positive for equities during the Covid-19 crisis.

As markets price a reduction in liquidity, we could see upward pressure on real bond yields. Inflation breakevens may also fall as fears over a sustained inflation overshoot subside.

Our previous analysis suggests that this scenario could create both winners and losers.

Cyclical industries such as financials and energy should continue to do well amid higher real yields, while more defensive industries should underperform.

However, the broader value versus growth trade could stall as falling inflation expectations are generally more negative for value than higher real rates are for growth (and vice versa).

At the regional level, higher real rates coupled with lower inflation breakevens appear to be the worst possible outcome for EM equities.

Meanwhile, US and Japanese equities are poised to outperform given their positive beta to real yields and negative beta to inflation breakevens.

To be clear though, this assumes other economic variables remain constant, which in practice is rarely the case.

Given the high weight of financials, it’s possible that UK and European equities could also perform well.

For example, financials represent 18% of the MSCI UK Index, 15% of the MSCI Europe (ex UK) Index but only 11% of the MSCI USA Index.

It could be a tight race ahead.