Rate cuts spark switch out of cash

Analysts say the Reserve will influence much of the year, writes Clancy Yeates.

Analysts say the Reserve will influence much of the year, writes Clancy Yeates.

Record low interest rates and sluggish economic growth are shaping up as the defining features of this year, prompting investors to seek out defensive stocks with the potential to pay healthy dividends.

As much of the world grapples with recession-like conditions this year, markets are betting the Reserve Bank will follow the lead of central banks overseas and cut the cash rate further from its current level of 3 per cent.

While it is hoped lower borrowing costs will stoke recovery in the non-mining sectors, rate cuts are also likely to have major consequences for investors, by eroding returns from term deposits.

An investment analyst at UBS Wealth Management, Abby Macnish, expects lower interest rates to drive more people who have been relying on fixed incomes into high-yielding stocks such as Telstra, which has a gross dividend yield of nearly 9 per cent.

"The focus for this year is the cash rate lower for longer," Macnish says. "People are switching out of cash as they realise that their term deposit rates are dropping and they need to replace that income."

A Credit Suisse strategist, Atul Lele, says the stocks most likely to deliver solid dividends are in defensive sectors such as utilities, infrastructure or real estate investments trusts.

Lele says these sectors may produce an income stream of about 6 per cent, in a year that is likely to feature deep cuts in interest rates and lower bond yields.

"As economic growth weakens more precipitously ... the RBA is likely to continue easing monetary policy, potentially up to 150 basis points over the next year," Lele says in a note this week.

He says other firms with good potential in the weaker domestic climate are industrials with a heavy overseas presence, such as Brambles or Amcor. These businesses depend more on the global economy, where Lele expects "stable" growth, compared with slowing in Australia.

Against these predictions of subdued domestic growth, a wave of optimism swept through global markets this week, pushing the Aussie dollar to a four-month high of US106ยข.

On Thursday, the European Central Bank also said it expected the region to bounce back later this year, as it held interest rates at record lows of 0.75 per cent.

Despite the lift in spirits, however, many analysts are doubtful the bounce in commodities will last. They are also pessimistic about the more cyclical parts of the Australian economy.

Firms exposed to swings in household spending - such as retailers and media firms - are seen as especially vulnerable to any rise in unemployment.

Banks - which delivered share price gains of more than 20 per cent last year - are also out of favour, due to slow credit growth and rising costs.

A Nomura analyst, Victor German, says he doubts banks can deliver bumper returns again this year, as much of the potential earnings growth has been factored into share prices. At the same time, a slump in the economy could crimp earnings by pushing up funding costs.

"The bank sector appears fully valued at current levels relative to its recent and long-term history," German says in a note.

The caution towards consumer-facing stocks was this week backed up by figures showing retail trade fell by a disappointing 0.1 per cent in November. October's interest rate cut also failed to spark a lift in private-sector housing approvals.

Nevertheless, some believe lower rates may be gaining traction, which could point to better times ahead for consumer-facing businesses.

A director of Deloitte Access Economics, Chris Richardson, says conditions in interest-rate sensitive sectors such as housing and retail are probably "better than people realise", pointing to solid growth in volumes of goods being sold. "Retailers are still doing it tough but many of them are doing it less tough now than they were a year ago," he says.

Citi's equity market strategist, Tony Brennan, also notes the number of earnings downgrades in recent months was below its average over the past decade.

Brennan says there could even soon be profit upgrades for two powerhouse sectors of the sharemarket - miners and banks - which may benefit from higher commodity prices and increased lending in response to lower rates, respectively.

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