European auto stocks may not see an immediate boost in the wake of interest rate cuts by central banks, despite hopes of increased affordability of new vehicles, Morgan Stanley noted in a note to clients on Wednesday.
Historically, the sector does not react quickly to interest rate cuts, and weak underlying demand, coupled with shrinking prices for new and used cars, usually takes some time to resolve.
“Lower interest rates alone cannot save the auto sector,” Morgan Stanley analysts noted in their report, stressing that while lower interest rates may help improve the affordability of cars, “underlying demand may take several quarters to improve.”
As a result, analysts remain cautious about European automakers and see margin risks looming over the sector.
Morgan Stanley’s macroeconomics team expects the Fed to deliver its first 25 basis point rate cut at its September FOMC meeting, taking the benchmark rate to 5.125%.
Analysts expect three such cuts before the end of the year. However, analysts warn that these cheaper funds may not be enough to offset the pressures in the auto sector.
The report also highlights that price declines tend to coincide with lower average selling prices (ASPs) as OEMs move to defend their market share.
This may help improve affordability, but could create a challenging environment for profit margins. “Our new vehicle affordability estimates already reflect lower rates, which helps to address industry pressures, but does not completely resolve them,” the report noted.
Moreover, the study shows that OEMs, as credit-sensitive stocks, may not benefit as much from lower bond yields as expected.
“Lower bond yields, while helpful for increasing affordability, may be a result of lower aggregate demand and are not always associated with tighter spreads,” Morgan Stanley said, while also noting that “further bullish signals would be signs of re-inflation in China.”
Morgan Stanley data also shows that European auto stocks underperform when yields fall rapidly. “The auto sector’s relative performance averages -7% in months when 10-year yields fall by more than 50 basis points,” the report notes, suggesting that rising bond yields have historically been more supportive of the sector.
Accordingly, analysts point out that the risk-reward profile of the sector remains weak for investors with a multi-year investment horizon.
“We continue to believe that the declining profit margins make the sector’s risk-reward ratio too weak,” the report said, warning that the current weak demand environment and high margin estimates still pose risks to European automakers.
Despite the pressure on automakers, Morgan Stanley’s analysis also touched on the role of inflation. The auto sector has previously benefited from higher prices, but “recent data highlights that the fundamental backdrop for auto pricing is now deteriorating,” with new-vehicle inflation in the US turning negative and dealer incentives rising.
“We see affordability as still limited,” Morgan Stanley said, citing weak underlying demand for new cars at current prices. The report also noted that Bavaria Motor Works AG (WA:) The recent earnings warning, which cited weak demand, particularly in China, as a major factor impacting margins.