European Shares Must Take Stock of Higher Bond Yields – Wall Street Journal

Updated June 10, 2015 6:41 a.m. ET

Europe's economies are picking up. European earnings are finally showing signs of life. But European stocks have a case of the bond-market blues.

The Stoxx Europe 600 is still up 12% so far this year. But it is down 7.2% from its mid-April peak and is back at levels last seen in February. Nerves over Greece and global growth are having an impact, but the biggest factor behind the decline looks to be the sharp moves in global bond markets. In less than two months, 10-year German yields have zoomed to over 1% from close to zero, breaking a rally that had lasted for more than a year. The speed of that move has unnerved other markets.

The base case for buying European stocks still holds: Europe's economies have emerged from the doldrums and are benefiting from low interest rates, low commodity prices and a weaker currency. That backdrop should help earnings rise. The good news is that equity valuations didn't follow bonds into absurdity: the Stoxx 600 trades on 15.7 times the next 12 months' earnings, according to FactSet. But higher risk-free rates will still have consequences for equity bulls.

Indeed, the shift in the bond market—where the process of chasing yields ever lower, lured by the siren call of quantitative easing, has come to an abrupt end—may be the most important thing stock investors have to call. Higher bond yields make defensive, bond-like stocks less attractive. But these were the safe-haven investments for stock pickers while the eurozone economy stagnated and economic risks were high.

The tide may be turning: Recent history suggests that sectors such as food and beverages and retailers underperform as bond yields rise, while sectors including banks, insurers and industrials should outperform, Goldman Sachs GS 1.63 % notes. That makes instinctive sense, and is starting to play out: European banks had lagged the Stoxx 600 index, but are now faring better.

Some might be concerned that history doesn't offer a good guide, since bond yields have never been so low, nor has monetary policy been so extreme. Stock investors might yet want to think about how bond investors respond to rising interest-rate risk and steeper yield curves: they reduce duration, or buy bonds that are less sensitive to movements in rates, such as high-yield corporate bonds, and short-maturity paper.

Equities can be treated similarly based on their sensitivity to changes in the discount rate. Equity duration is based on a stock's beta, or the way it moves relative to the market, as well as its dividend growth and the sensitivity of dividend growth to changes in the discount rate, HSBC HSBC 1.20 % notes. Short-duration sectors like banks and capital goods fare well on this measure, while food & beverage stocks languish. Italy, Germany, Spain and France top the list of countries with shorter equity durations, according to HSBC.

Bond markets need to calm down for equities to recover. But if that happens, then sticking with Europe but remembering that higher risk-free rates make a difference could yet be a winning strategy.

Write to Richard Barley at richard.barley@wsj.com