What are the bond yield effects on European equities? UBS answers

The rise in U.S. 10-year bond yields from 3.94% to over 5% has prompted UBS to analyze its impact on European equities. While higher yields typically act as a headwind to valuations, the firm notes that the effects are not uniform across the market. Since February, the real yield has increased from 1.68% to 2.67%. Strategists at UBS observed that during weeks when the 10-year yield rose, approximately 42% of the MSCI Europe index weight participated, compared to 64% during weeks when the yield fell.

They emphasize that controlling for the index return itself, every additional 10 basis points (bps) on the 10-year bond costs roughly 1 percentage point (pp) of index weight participating.

UBS highlights that the combination of yield level and speed of increase, rather than just the yield level, is crucial. When the 10-year yield was below 3%, even a 20-basis point weekly rise led to over 57% of the index moving higher, as rising yields were perceived as a sign of growth. However, when yields were between 4%-4.5%, breadth fell significantly, from 60% to 30% on down-yield weeks.

Above 4.5%, the level alone was not a concern. The firm notes that sharp weekly increases in yields pose the greatest risk, as the discount rate rises and the growth hurdle required for investor attention increases, leaving fewer companies able to clear it.

UBS stresses that the rise in yields is due to genuine growth strengthening and broadening, rather than just a term-premium accident or inflation scare. They point out that an industrial capacity expansion cycle is emerging across sectors like defense, AI equipment, infrastructure, and power. This is significant because industrial activity has a higher velocity of money compared to services.

The strategists view companies with the lowest beta to rising yields as better investments due to their cheaper valuations and higher cyclicality and growth in earnings. The key distinction is not between cyclical and defensive companies in the abstract, but rather whether earnings growth is accelerating fast enough, starting from a cheap enough valuation, to offset the multiple compression brought about by higher yields.