Morgan Stanley has added its voice to a gloomy chorus forecasting deep cuts to interest rates, expecting a fall to 1 per cent. But the weakening impact of central bank stimulus means the sharemarket will find little joy, leading the investment bank to stick to its year-end target of 4800 points.
In a bearish note to clients, Morgan Stanley strategists Chris Nicol and Daniel Blake tip the Reserve Bank of Australia will cut the official cash rate to 1 per cent by the first half of 2017.
They say the government's conservative approach to infrastructure stimulus and the housing cycle at its peak, the need for a weaker currency will force the central bank to cut deeper into its easing cycle.
It comes after Macquarie Bank last week also forecast interest rates to fall to 1 per cent or lower, lamenting the lack of fiscal stimulus that left the RBA with the responsibility to keep a lid on the currency.
However, Morgan Stanley says the effect of the cut will be more about risk management than economic stimulation.
"Like other [developed markets], Australia has passed the inflection point of outsized positive impacts from easier monetary policy," the strategists said.
Australia had been removed from the challenges of flagging inflation and growth that have plagued its developed markets peers, but that changed after the disappointing first-quarter inflation reading, which fell below the RBA's 2 to 3 per cent target range.
But while the sharemarket has embraced the central bank's first cut in a year in May, adding around 2 per cent since, the disconnect between companies' weak earnings per share growth and high valuations means the rate boost won't turbocharge share prices.
Morgan Stanley has kept its year-end target of 4800 – a fall of more than 9 per cent from its current level near 5300 points – that it set at the beginning of the year.
"The next move lower in rates, in our view, will have an objective of risk containment, and will be unlikely to turn market earnings momentum in the short term," the strategists said.
Pressure on bank margins
Among the sectors to be hurt by a rate cut are the banks, which account for the biggest industry in the local sharemarket. A rate cut would put pressure on net interest margins, which is not being factored into consensus estimates, the strategists warned.
Each 25-basis point cut – a fall to 1 per cent would require three such cuts from its current level at 1.75 per cent – would reduce the margins of the big banks by around 2 to 3 basis points.
The requirement on the banks for a 100 per cent net stable funding ratio by January 2018 will mean the banks will become more competitive in their deposit rates.
But lower cash rates should mean investors will remain drawn to the relatively high dividend yield of the banks at around 6 per cent, the strategists said, however they expect payouts to be cut in 2017.
A 75 per cent fall in interest rates would have a negligible effect on consumer stocks, as savings generated from lower borrowing rates are likely to be saved rather than spent, the strategists said. Defensive stocks are likely to remain expensive in this scenario.
Citi, meanwhile, is signalling the end of the traditionally high-yielding stocks' stellar run. The renewed speculation that interest rates will rise in the US again as early as next month, will lead to rising bond yields and reduce the attractiveness of the so-called "bond proxy" stocks, usually real estate investment trusts, utilities, infrastructure and telcos.
Since the US Federal Reserve first raised interest rates in December, these defensive sectors haven't continued the outperformance they enjoyed in recent years, Citi equity strategist Tony Brennan said in a note.
