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Fed cuts: boost for utilities but bad news for banks

Lex Hall  |  01 Aug 2019Text size  Decrease  Increase  |  
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The Fed’s interest rate cut is a boost for utilities and gold investment but will weigh on financial services, resulting in lower yields and lower profitability, say Morningstar analysts.

The Federal Reserve has cut interest rates to shore up the economy against risks, including global weakness, but the head of the US central bank says he does not view the move as the start of a lengthy series of rate cuts.

Fed chairman Jerome Powell cited global weakness, simmering trade tensions and a desire to boost too-low inflation in explaining the central bank's decision to lower borrowing costs for the first time since the 2008 global financial crisis and move up plans to stop winnowing its massive bond holdings.

Financial markets had widely expected the Fed to reduce its key overnight lending rate by a quarter of a percentage point to a target range of 2.00 per cent to 2.25 per cent, but many traders expected a clearer confirmation of forthcoming rate cuts.

The Fed’s decision could prompt the Reserve Bank of Australia to further lower the cash rate from its historic low of 1 per cent. RBA governor Philip Lowe has already signalled a prolonged period of low rates. Inflation is failing to reach the 2-3 per cent target and economists expect a third rate cut this year if the unemployment rate fails to fall below the current 5.2 per cent

According to our Morningstar equity analysts, utilities and financial services shares tend to be particularly sensitive to rate expectations. Travis Miller, utilities and energy equity strategist, Eric Compton, financial services equity analyst, and Kristoffer Inton, director of basic materials, offer their perspectives on what lowered interest rates might mean for their respective industries.

Positive impact for utilities

“Low interest rates are a substantial positive for utilities and a key reason they are trading at historically high levels," says Travis Miller. "Utilities were the most overvalued sector in our entire equity coverage universe, and the big reason is low interest rates have lowered utilities’ borrowing costs and made their dividends more attractive for yield-seeking investors.”

Market-cap-weighted average valuations sitll hovered close to zero last quarter, with a few notable exceptions, as seen in the chart below. Utilities remain the most overvalued sector, followed by real estate, and consumer defensive. The largest comapnies in these sectors are driving valuations, as the market-cap-weighted averages deviate from their static medians.

Morningstar price/fair value distribution US sector

Morningstar price/fair value distribution by US sector

Source: Morningstar quantitative and analyst fair value data

Drag on financial services

“For banks, lower interest rates are broadly a negative," says Eric Compton. "Lower rates result in lower yields on earning assets and this causes banks to earn lower interest income, decreasing their profitability. Lower rates on the long end of the yield curve can stimulate increased mortgage activity, which can result in more fees for banks. But, on the whole, lower rates would result in decreased profitability for banks.

“If lower rates lead to a stronger economy, this could arguably be better than a would-be recession, as the banks are sensitive to an economic downturn, but it is hard to establish the counterfactual to that and quantify it (would there have been a recession if rate cuts had not occurred?).

"One key point I would highlight is that there is a big difference between going to zero for the Federal Funds Rate for over 5 years (which is what we did last time) versus having 1-3 interest rate cuts which will eventually reverse in a couple of years. We are already forecasting the latter scenario in our banking models, and it resulted in low single digit declines to our fair value estimates. The former scenario would be more adverse.”

Gold attractiveness restored

Kristoffer Inton on the impact for the gold mining industry: “All else equal, the turn in the Fed’s sentiment on the target rate has restored the attractiveness of investment demand for gold, a sharp turn from the trend during the last few years. Gold ETFs have seen inflows in recent months, as the Federal Open Market Committee’s return to rate cuts have fuelled gold’s resurgence.

"At present, we think the market is pricing in a scenario of a low to negative real interest rates from a weak economy that necessitates rate cuts, but at the same time, normal inflation stemming from a healthy economy—scenarios that appear unlikely to occur simultaneously.

“On the back of rising investment demand, gold prices have settled above $1,400 per ounce, more than $100 higher than just a couple months ago. Gold now sits above our forecast for a nominal gold price of $1,300 per ounce by 2020.”

 

is content editor for Morningstar Australia

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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