In the past two months, there has been a dramatic decoupling between bond yields and cyclicals, with the former falling while the latter have outperformed. In our view, it is unlikely that European cyclicals are wrong: cyclicals relative to defensives are 0.5 standard deviations cheap, have lagged European PMIs, and overall equity sector risk appetite is even now 0.6std below its norm.
There are a number of other factors which suggest, in our view, that this anomaly between bond yields and cyclicals will be resolved by a rise in yields: (i) The rise in ISM new orders or industrial commodity prices is consistent with higher bond yields. The oil price is up c.55% from its low but US 10-year bond yields are down c.20bps since the low in the oil price; a rise in oil price of this magnitude has never historically been associated with a fall in bond yields; (ii) There are some signs of stronger US inflation (with a slight uptick in core PCE inflation, and the Atlanta Fed wage tracker); (iii) Bond yields are currently 1.4std below our simple model's estimate of fair value; and (iv) Often yields rise in the 3-6 weeks following a commencement or acceleration of QE.
Investment implications: (1) Sell expensive European bond proxies such as consumer staples and regulated utilities (with the former appearing to price in both negative Bund yields and a collapse in US ISM); we have Underperform ratings on Danone, Henkel and Pennon; (2) We would look to buy the beneficiaries of rising bond yields, and in particular banks (which in Europe's case have decoupled from macro momentum to an extraordinary degree); (3) Focus on the 'safer' plays in composites/life insurers. These stocks tend to outperform when bond yields rise, especially those with significant US exposure (such as Prudential and Aegon). Critically, they are the most sensitive sector to credit spreads (after banks) and should have performed better given the collapse in the iTraxx index. Earnings momentum, dividend momentum and yield relatives all look attractive (AXA and L&G); (4) We stick to our overweight of European domestic demand-related cyclicals. We are more cautious of US cyclicals as they appear relatively expensive and US lead indicators have been weaker than those in Europe
What is the explanation behind the decoupling between bond yields and cyclicals? In our view, the most important explanation is Janet Yellen, whose language became more dovish as markets, PMIs and financial conditions all improved. As a result, the market is now pricing in around one rate rise this year, while our economists expect two rate hikes this year