The ASX stocks most exposed to the next leg higher in rates

Interest rates are once again becoming a problem for Australian equities.

Australia’s 10-year government bond yield is sitting around 5.37%, its highest level since May 2011, as rising oil prices, inflation concerns and expectations of further monetary tightening put pressure on bond markets.

While higher rates affect the market as a whole, some sectors and stocks will feel more pain than others.

Against that backdrop, a recent Australian Equity Strategy note from UBS strategists Richard Schellbach and Lily Huang provides an interesting roadmap. They analysed how ASX sectors and individual stocks have historically behaved as short- and long-term interest rates rise.

The results reveal some clear pressure points.

Property sits squarely in the firing line

No part of the market looks more exposed than real estate. UBS found Real Estate and Consumer Discretionary have been the two sectors most negatively correlated with increases in short-term interest rates over the past three years.

“The vulnerability of the housing and consumer complex is clearly apparent,” the UBS strategists say.

Among individual stocks, Stockland (ASX: SGP) has been particularly sensitive, recording a -0.42 correlation with short-term rate moves. Mirvac (ASX: MGR) follows at -0.36, while GPT Group (ASX: GPT) sits at -0.31 and Dexus (ASX: DXS) and Scentre Group (ASX: SCG) at -0.30.

The relationship becomes even more pronounced when long-term bond yields rise.

GPT has recorded a -0.50 correlation with the Australian 10-year yield, the most negative reading among the ASX 100 stocks in UBS’s analysis. Charter Hall (ASX: CHC) and Mirvac follow at -0.42, Dexus at -0.41, and Stockland and Scentre Group at -0.40.

My read is that two forces are at work here. Higher rates can increase financing costs for capital-intensive property businesses, while higher bond yields can also make the income offered by property assets relatively less attractive and place pressure on valuations.

That latter point is my interpretation rather than an explicit conclusion made by UBS in the note. What UBS’s numbers make clear is that, historically at least, property has been the epicentre of rate sensitivity.

Consumers aren't far behind

The second pressure point is the consumer. Wesfarmers (ASX: WES) appears among the stocks vulnerable to both short- and long-term rate increases. Its correlation with short-term rates is -0.29, worsening to -0.35 against the 10-year bond yield.

JB Hi-Fi (ASX: JBH) has correlations of -0.24 and -0.25 respectively. Schellbach and Huang put this within a broader late-cycle framework.

“High/rising rates are associated with late economic cycles,” they say.

In that environment, UBS argues debt servicing, affordability and cost-of-living headwinds continue to intensify for consumer and housing-related equities.

For me, that makes the consumer names particularly interesting. There is potentially a double hit - higher yields can pressure the valuations investors are willing to pay, while further RBA hikes can directly squeeze the customers walking through their doors.

Some less obvious names are also caught in the rates trade. SEEK (ASX: SEK) has historically shown a -0.35 correlation with short-term rate moves, while REA Group (ASX: REA) sits at -0.24 and CAR Group (ASX: CAR) at -0.25. Growth names including Xero (ASX: XRO) and TechnologyOne (ASX: TNE) have also displayed negative correlations.

Long-term yields create a different problem

One of the more useful distinctions in the UBS research is between RBA rate increases and movements further along the yield curve.

“Versus moves up in short term interest rates which impact most negatively on consumer housing plays, the moves up from longer bond yield tend to de-rate high PE and/or long duration stocks most,” the UBS team says.

That brings several additional large caps into focus. Transurban (ASX: TCL) has recorded a -0.40 correlation with long-term yields, while APA Group (ASX: APA) sits at -0.29. Even Commonwealth Bank (ASX: CBA) has recorded a -0.29 correlation.

UBS specifically identifies Transurban, APA Group, Wesfarmers and CBA as stocks that could underperform if long-term rates continue rising.

To my mind, this is probably the more interesting risk for equity investors. An RBA hike has obvious implications for households and interest-rate-sensitive companies. But a sustained repricing of long-term yields potentially reaches much further into the market by changing the rate investors use, implicitly or explicitly, to value future earnings.

And with the 10-year yield now around 5.37%, that question has become even more pertinent.

Where can investors hide?

One sector is conspicuously absent from the casualty list - energy. In fact, energy is the only sector UBS found to have a visible positive correlation with higher policy rates.

“Energy sits as the only sector that has a visible positive correlation to higher policy rates,” Schellbach and Huang say.

Whitehaven Coal (ASX: WHC) stands out, with correlations of +0.15 to short-term rates and +0.24 to long-term yields. Woodside Energy (ASX: WDS) sits at +0.11 and +0.07 respectively, Ampol (ASX: ALD) at +0.09 and +0.11, and Santos (ASX: STO) at +0.06 and +0.10.

UBS sees that as consistent with where we are in the economic cycle.

“Capacity constraints produce inflationary conditions which favour ‘price makers’ over ‘price takers’,” the strategists say.

On that basis, UBS believes Mining and Energy are best placed to outperform.

There is an important caveat here. Correlation isn't causation, and these historical relationships aren't forecasts. A higher cash rate doesn't automatically send Stockland lower or Whitehaven higher.

The UBS analysis provides a useful map, however, of where the pressure is most likely to show up if Australia's rate problem gets worse.

Right now that map is unusually clear - property and consumer stocks are closest to the firing line, long-duration equities become increasingly vulnerable if bond yields keep climbing, and the market's “price makers”, particularly in energy, may be among the few beneficiaries of a higher-for-longer world.