Value and banking stocks set to outperform on rising yields​​​​​​​​

While rising treasury yields have send markets sharply lower, correlation analysis highlights which markets could outperform as we move through this recovery.

Treasury yields on the rise, but selloff proves uneven

The rise in treasury yields has provided a major theme for markets over the past week, with traders increasingly fearful of what that could mean for demand in the equity space. Casting our minds back to 2020, the onset of the crisis saw yields tumble to record lows, providing little reason for investment managers to allocate assets towards treasuries despite the desire to diversify their portfolio.

Instead it seemed that equities became the only game in town, with US growth stocks taking the lead. That tech outperformance saw the Nasdaq hit record highs just two-months after touching its 2020 low of 6644. However, with the economy expected to recover over the course of 2021, we are seeing yields rise to reverse that story. This risk-off move has investors worried, with the 2021 economic bounceback expected to bring further upside for yields.

However, a deeper look provides a clue of where the funds are flowing (and it’s not treasuries). The chart below highlights how close the correlation is between the US 10-year treasury yield and the value/growth ratio (Russell 2000/Nasdaq 100). While the Russell 2000 has understandably lagged the Nasdaq over the course of 2020, things appear to be turning in favour of value names as we head towards a reopening phase.

Nasdaq at risk of bearish reversal breakdown

That shift out of growth has hit the Nasdaq hard, with the index falling back towards the crucial 12844 support level. Coming off the back of a trendline break, there is a strong chance we could see the index break support to bring a potential wider pullback into play.

Where to look when markets are heading south

That tech weakness could come as a result of reallocation towards value, yet the sheer size of those firms do provide downward pressure for any other indices such as the S&P 500 which contain them. Furthermore, the wider risk-off sentiment does drive downside for markets such as the Russell 2000 that are more commonly associated with value.

As such, we are looking at relative outperformance for value over growth if yields continue to rise. However, there are some sectors which are particularly well correlated to the 10-year yield.

The banking sector is one particular area of interest, with the procyclical nature of financial stocks meaning that we tend to see such companies outperform as yields rise. Of course, rising yields also provide greater expectation of higher economic growth and tighter monetary policy. The chart below highlights how the iShares US Financials ETF has been closely tracking the trajectory of US yields throughout the past year.

UK banks look attractive

Bringing things back to the UK, that US 10-year relationship also correlates well with banks on this side of the Atlantic. The relationship between UK banking stocks and the 10-year yield is remarkably close, bringing greater confidence of further upside from here.

With the UK roadmap now explicitly laid out, and Rishi Sunak expected to extend the furlough scheme through to May, the risks for banks are certainly dissipating. As such, while we could see further downside for wider stock markets as yields rise, banking stocks provide a good hedge that looks likely to gain ground if we see a continuation of this recent treasury market trajectory.

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