Bernstein cautions rising U.S. yields remain an underpriced threat to Asian equities

Rising U.S. Treasury yields present a greater danger to Asian equities than their current price-to-earnings ratios suggest, Bernstein warns, as investors may be underpricing the scope for further valuation compression with the 10-year yield approaching 5%.

Since 2022, elevated nominal and real U.S. yields have weighed heavily on Asian share valuations. The artificial-intelligence rally has partially offset that pressure this year, but Bernstein notes the June-July selloff removed some of the market's most extreme valuation excesses without fully dispelling the danger from higher rates.

The issue is especially critical now, as the U.S. 10-year yield approaches 5%, a level Bernstein says is not yet fully priced into Asian equity valuations. The brokerage notes that the only past episodes of yields moving above 5% - around 2000 and 2007 - coincided with sharp multiple compression.

At first glance, Asian stocks do not appear expensive on forward P/E ratios, because strong profits have lifted consensus estimates.

Bernstein warns that this masks several fragilities. Earnings expectations in South Korea, Taiwan, Japan and Thailand are at record levels, amplifying the risk that earnings growth peaks just as borrowing costs climb.

Book-value valuations offer a less reassuring view. South Korea and Taiwan remain at record price-to-book multiples, while Japan and Australia trade above their 2021 peaks. Bernstein also points out that the spread between earnings yields and bond yields - effectively the compensation for holding equities rather than bonds - is near record lows in Japan, South Korea, Taiwan and Australia.

Why tech may stay vulnerable

The AI trade has made the interest-rate question even more crucial. Asian technology stocks trade at about 23.6 times forward earnings, near their five-year average, implying reasonable valuation on that basis. Yet price-to-sales ratios stand at record highs, leaving the sector exposed if bond yields push higher.

Historical evidence also favors short-duration equities in rising-yield periods. Since 2020, Bernstein's short-duration portfolio has delivered an annualized return of 10.9%, compared with 8.9% for long-duration stocks and 10.1% for the broader market.

Long-duration stocks, which tend to be more sensitive to discount rates, have underperformed the wider market by about nine percentage points annually since 2020, while short-duration names have outperformed by roughly five percentage points.

One exception may exist: Bernstein says Chinese equities could benefit most from higher yields because they feature prominently in its short-duration basket.

Inflation adds further risk. Bernstein notes that inflation already exceeds official targets in South Korea, India, Australia and the Philippines, and it expects price pressures to build this year in several other Asian economies.

Meanwhile, U.S. real yields are at their highest levels in 15 years, so any additional increase could have an outsized impact on Asian markets.