Equities: Long Bond Yields Have Risen In Recent Months. What Are The Consequences?

Long bond yields have increased significantly in recent weeks. The 10-year German bund has gained nearly 40 basis points in less than a month. In the US, the 10-year Treasury yield reached 2.4% at the beginning of July. These major and sudden upward movements are causing ripples on equity markets.

The rise in interest rates, propelled by the change in rhetoric of central banks in developed countries, is causing ripples on equity markets. Firstly, it raises the question of valuation levels. Indeed, higher interest rates are making equities automatically dearer in valuation models. Secondly, rate movements will influence the relative appetite for the different sectors of the economy. A rise in rates may be negative for certain activities (e.g. squeezing profit margins), but positive for others (e.g. improving profitability for banks), or may simply reflect an economic recovery and therefore a take-off of the more cyclical activities (higher revenues). Not surprisingly, the sectors which are most sensitive to a rise in interest rates are financials (see previous post on equities) and cyclical sectors, such as automobile, materials, industrials and construction.

However, other parameters must be taken into account for good sector-picking. In view of the recent rally in stock markets, the valuation level is a decisive criterion. Although many cyclical sectors appear expensive at present, valuations of European financials are still offering upside potential. Accordingly, our simple exercise with statistics was fairly revealing.  Over the past 15 years, we have seen a negative correlation between the price/book value ratio and the real yield over 5 years in Europe. Intuitively, this relationship reveals a correction risk in the event of stretched valuations. Considering the current value of this ratio (1.03) for the European financial sector and the yields seen over the past 15 years, the average yield for this sector should be around 3.6% over the next 5 years.  On the other hand, in the US, valuations are more stretched, judging from the huge amount of news already priced in by the markets. The price/book value ratio expected in the US financial sector is currently 1.3, suggesting an average correction of around -1.1% annualised for the sector over the next 5 years, based on yields over the past 15 years.

In short, European financials are currently more attractive than their US peers. The gradual increase in long bond yields in Europe, coupled with a continuation of decent macro-economic data should help to drive their good performance.