UBS: Rising Yields Squeeze European Stocks, But Favor Cyclical Value

The sharp rise in U.S. Treasury yields is creating a headwind for European equities by narrowing market participation, but the underlying driver is positive economic growth, according to a new analysis from UBS. The firm's strategists argue that while higher rates pressure valuations, the impact is not uniform and certain sectors are well-positioned to outperform.

Market Narrows Under Pressure

With the U.S. 10-Year Treasury yield climbing from 3.94% at the end of February to over 5%, European stocks have struggled more with the rapid pace of the increase than the absolute level. UBS found that since March, weeks with rising 10-year yields saw an average of only 42% of the MSCI Europe index's weight gain in value. In contrast, during weeks when yields fell, 64% of the index weight rose.

According to the note, the market is not necessarily falling on higher yields but is "narrowing under them." The combination of the yield's level and the speed of its ascent is what erodes market breadth. For example, when the 10-year yield was between 4% and 4.5%, a weekly increase of more than 20 basis points caused market breadth to fall from 60% to just 30%.

"As the discount rate rises, the growth hurdle required to hold investor attention rises with it, and fewer companies clear it," UBS strategists stated.

Yields Rising for the 'Right Reason'

UBS contends that the current yield surge is not the result of an "inflation scare" but is instead a reflection of strengthening and, crucially, broadening economic growth. The bank points to the emergence of a new industrial capacity expansion cycle across multiple sectors for the first time in a generation.

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Key areas driving this cycle include:

• Defence
• AI equipment
• Infrastructure
• Power

This trend is significant for interest rates because industrial activity "carries a higher velocity of money" compared to the services sector, a dynamic markets have not had to price in for decades, according to UBS.

Investment Implications

Against this backdrop, UBS suggests investors should focus on companies whose performance has a low correlation, or beta, to rising yields. The key is to find businesses where accelerating earnings growth, combined with a cheap starting valuation, can successfully offset the multiple compression caused by higher discount rates.

UBS concluded that the cyclical value segment of the market possesses both of these characteristics. These companies tend to have lower valuations and earnings that are more sensitive to the broadening economic and industrial growth that is pushing yields higher.