How Different Regions and Sectors Respond to Changes in Bond Yields

The ongoing COVID-19 pandemic has had a significant impact on the global economy, leading central banks to adopt unprecedented monetary policy measures to cushion the blow. The Federal Reserve has been at the forefront of this effort, keeping interest rates low and buying bonds to provide liquidity to the market. As the US economy starts to recover and inflation expectations rise, the Fed is now planning to reduce the pace of its monthly bond purchases and raise interest rates in 2022. This has led investors to worry about the potential impact on equity valuations, particularly given the strong rally in the stock market in the past year.

While most equity markets will respond to changes in the global benchmark discount rate, the 10-year US Treasury yield, not all markets will react in the same way. Therefore, investors with the flexibility to adjust their global asset allocation tactically should take note of these differences.

Bond Yields: Real vs. Expected Inflation

Bond yields consist of a real interest rate and expected inflation, and each component can influence stock prices differently. Rising inflation expectations have been associated with strong emerging market equity outperformance over the past decade, driven by improving global growth prospects that benefit export-oriented regions. However, if higher yields are driven by real rates, EM companies could face higher borrowing costs and underperform. Meanwhile, value stocks tend to outperform when real yields are rising, while growth stocks tend to underperform due to their vulnerability to changes in the discount rate.

Industry Groups: Cyclicals vs. Defensives

The impact of rising bond yields varies among different industry groups. Historically, cyclical industries like banks, energy, and materials outperform when yields increase, while defensive industries like food, telecoms, and utilities underperform. However, some industries exhibit a weak relationship with yields and perform in line with the market average.

At the same time, investors should be aware that certain industry sectors have already priced in rising bond yields. For example, bank stocks have rallied in recent months as investors anticipate higher interest rates, and the same can be said for energy stocks. As a result, these sectors may not necessarily outperform in the near term.

Regional Level: Winners and Losers

Higher real rates and lower inflation breakevens could be the worst outcome for emerging market equities, while US and Japanese equities are poised to outperform given their positive beta to real yields and negative beta to inflation breakevens. UK and European equities could also perform well due to the high weight of financials in their indices.

In addition, investors should be mindful of the differences in how different regions are impacted by rising bond yields. For example, the European Union (EU) has a higher proportion of defensive sectors like healthcare and consumer staples, which may not perform as well in a rising yield environment. On the other hand, the US has a larger weighting of cyclical sectors like industrials and materials, which could benefit from higher yields.

As the Fed's hawkish shift in tone signals a potential reversal in the combination of low real rates and higher inflation breakevens that have supported equities during the Covid-19 crisis, investors should consider selective equity exposure. While cyclical industries are expected to perform well amid higher real yields, the value versus growth trade could stall as falling inflation expectations are generally more negative for value than higher real rates are for growth. Therefore, investors who have the flexibility to tactically adjust their global asset allocation should pay close attention to the differences in how different regions and sectors respond to changes in bond yields.