Europe's stock market rally has become increasingly concentrated, elevating risks while investor confidence in the economic outlook diminishes. Over the past month, European stocks have lagged behind their US counterparts, despite more positive economic surprises in Europe and concerns surrounding artificial intelligence spending by major American tech companies. The situation is further complicated by oil prices exceeding $100, which increases the likelihood of further interest rate hikes on both continents.
Rising US Treasury yields are contributing to this struggle, creating a challenging environment for European equity valuations. The US 10-year Treasury yield, having climbed from 3.94% at the end of February to over 5%, has squeezed European stocks. According to UBS, the market is not necessarily falling due to higher yields but is experiencing a narrowing of gains, with market breadth significantly impacted by both the level and the rapid pace of yield increases. For instance, when yields were between 4% and 4.5%, a weekly increase of more than 20 basis points caused market breadth to drop from 60% to just 30%.
UBS analysts Gerry Fowler and Sutanya Chedda noted that since March 1, weeks with rising 10-year yields saw an average of only 42% of the MSCI Europe index's weight gain in value, compared to 64% during weeks when yields fell. This 22-percentage-point gap is the widest in their sample, indicating a significant regime change in how markets are pricing rate risk. They suggest this yield surge reflects broadening economic growth and an industrial capacity expansion cycle, rather than an "inflation scare."
In this environment, UBS recommends investors focus on cyclical value stocks. These companies tend to have lower valuations and earnings that are more sensitive to the broadening economic and industrial growth driving higher yields. Energy, banks, chemicals, and basic resources have been among the primary gainers over the past three months, while sectors like construction, consumer products, telecoms, utilities, and food and beverage stocks have underperformed.
