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Why this top broker just upgraded Sydney Airport to buy

Bond proxies and other interest rate sensitive stocks are taking a pummeling today as investors trim expectations of a bigger than normal interest rate cut by the US Federal Reserve next week.

The market had been pricing in a more than two-thirds chance that the US central bank would slash interest rates by 50 basis points by month end due to the slowing global economy from the Trump trade war, but revisited that assumption last night.

A 50-point move is twice of what the Fed would normally undertake and the last time it made a more than 25 basis point cut to the official rate was during the GFC in 2008.

But investors are hooked on rate cuts and loose money. A 25-point cut just isn’t enough to put them on a high and this triggered a fall in US equity markets, which is dragging on the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index.

“Buy the dip” for bond proxies?

Our benchmark is down 0.4% in after lunch trade and it’s ASX stocks that are correlated to bond yields that are taking the brunt of the selling.

This includes the Ausnet Services Ltd (ASX: AST) share price, the Transurban Group (ASX: TCL) share price and the Sydney Airport Holdings Pty Ltd (ASX: SYD) share price.

But today’s dip could be a buying opportunity – at least for the SYD share price as Morgans upgraded the stock to “add” from “hold” even as it revised down its traffic forecasts for the nation’s busiest airport due to easing economic growth.

The broker has turned bullish on the stock as its view on declining government bond yields has more than offset the near-term dip in passenger numbers.

“Government bond yields have continued their long-term downward trend. These yields are used as a proxy for the risk free rate (RFR) in our DCF cost of equity (COE),” said Morgans.

“We have decreased the COE from ~8% pa to 6.8%, as we reduce the assumed RFR from 3.75% to 2.5% pa [per annum].”

Falling bond yields a big boost for stock valuation

The change in the RFR has lifted Morgans’ price target on Sydney Airport by $1.10 to $8.71 per share, giving the stock a potential total 12-month return of over 10% if dividends are included.

The broker thinks its being conservative with the upgrade given that it has not fully factored in a drop in the 10-year Commonwealth Government Bond (CGB) yield. If it did, Morgans valuation would jump to $9.90 per share.

If you are worried that a smaller rate cut by the Fed would trickle down to impact on the 10-year CGB, you shouldn’t.

While there is some correlation between US interest rates and global bond yields, the impact on long-dated bonds is weak. Interest rates influence shorter-dated bonds (typically going out to two years), while the long-term economic and inflationary outlook have a bigger impact on the 10-year bond yield.

Most economists are expecting low rates and subdue inflation to be a key feature for several years and that means the RFR is likely to stay depressed for a while yet regardless of what the Fed announces next Wednesday.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. Connect with him on Twitter @brenlau.

The Motley Fool Australia owns shares of and has recommended Sydney Airport Holdings Limited and Transurban Group. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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