Trading Strategies: a catalyst for this blue-chip’s outperformance

Last month’s 0.5 percentage point fall in annual inflation has prompted a degree of excitement among investors regarding future interest rate cuts. Indeed, an increasing number of stock market investors now believe that the Bank of England will cut interest rates at a faster pace than previously anticipated. After all, inflation now stands at just 1.7%. This is its lowest level since April 2021 and is substantially less than the central bank’s 2% target.

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Similarly, expectations of a rapid rate of monetary policy easing in the US and the eurozone appear to be growing as inflation across developed economies continues to fall. Although inflation in the US is still 40 basis points above the Federal Reserve’s 2% target, it has steadily declined over recent months. In the eurozone, meanwhile, it is at the same level as in the UK.

Upbeat economic prospects

A modest rate of inflation, though, does not necessarily mean that interest rates will fall at a rapid rate. Certainly, interest rates and inflation are very closely linked. The former, for example, increased at a brisk pace across developed economies during 2022 and 2023 in response to rampant inflation. But an inflation rate that is within touching distance of central bank targets, and remains subject to a degree of volatility in the short run, is unlikely to prompt a sudden dovish shift among policymakers.

The case against a faster pace of rate cuts is strengthened by the economy’s impressive outlook. According to the International Monetary Fund’s (IMF) latest forecasts, the US economy is expected to produce growth in excess of 2% both this year and next year. The UK’s growth rate, meanwhile, is due to rise from 0.3% last year to 1.1% this year and then to 1.5% next year. Similarly, the eurozone’s growth rate of 0.4% last year is set to double this year and increase by a further 50% to 1.2% next year.

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A scenario where inflation is close to central bank targets and the economy is growing at a brisk pace means a fast rate of monetary policy easing may not be required. Central banks may be content to press ahead with a more pedestrian rate of interest rate cuts and adopt a “wait-and-see” approach regarding their impact.

Cyclical stocks

Of course, interest rates are extremely likely to rapidly fall if inflation continues its decline and deflationary risks appear on the horizon. Likewise, if GDP growth falters over the coming months, with several upcoming geopolitical risks such as the Budget and US election having the capacity to impact negatively on the economy’s prospects, central banks can speed up the process of monetary policy easing in an effort to avoid a recession. Since inflation is already close to central bank targets, policymakers have plenty of scope to respond to the threat of a prolonged economic slowdown.

A faster pace of interest rate cuts would, of course, be likely to have a positive impact on the economy’s growth rate. Certainly, there could be a degree of turbulence in the short run as the presence of time lags means the full impact of monetary policy easing would take many months to be felt. Ultimately, though, a faster pace of rate cuts would provide improved operating conditions that particularly benefit companies which are reliant on the economy’s performance.

As a result, the outlook for cyclical stocks is becoming increasingly appealing. On the one hand, the prospects for GDP growth across developed economies are currently upbeat. And even if there is a slowdown in economic activity levels over the short run, the presence of modest inflation means that interest rates can be cut at a swift pace if necessary. This should mean that cyclical companies enjoy a sustained period of sound trading conditions that are conducive to improved financial performance.

In many cases, moreover, cyclical firms are financially sound and have solid competitive positions. Buying a diverse range of them now and holding for the long term could lead to relatively strong returns.

Earnings growth potential

Source SharePad. Data as at 28 October 2024. Past performance is not a guide to future performance.

The performance of FTSE 100 member Sage Group (The) (LSE:SGE) is set to be bolstered by an upbeat economic outlook. The company provides payroll, finance and accounting solutions to small and medium-sized businesses across a wide range of industries. It should therefore benefit from their sound financial performance amid strong GDP growth, with its exposure to the UK, Europe and North America meaning it is closely aligned to the economic prospects, and monetary policy, of several major developed economies. Indeed, those three geographies accounted for a combined 92% of its revenue in the latest financial year.

Of course, the company’s recent financial performance has been relatively strong. Its latest trading update stated that sales growth in the first three quarters of the current financial year was in line with previous expectations, with the firm still on track to deliver a 9% rise in organic revenue for the full year. It is currently forecast to generate a 14% annualised rise in earnings per share over the next two financial years, as margin growth provides an additional catalyst to its bottom line. The company is expected to release its full-year results on 20 November.

A competitive advantage

While Sage’s financial performance is set to be bolstered by an improving economic outlook that boosts the operating environment of its customers, the firm’s business model is relatively resilient. Although many cyclical companies experience significant volatility in their financial performance during periods of economic uncertainty, the recurring nature of the firm’s revenue means it enjoys a relatively predictable outlook. In the first half of the current financial year, for example, 97% of its sales were recurring. This is one percentage point up on the previous year.

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The company also benefits from a clear competitive advantage, with its customers being discouraged from switching to rivals due to the perceived time, effort and potential costs of doing so. For some of its customers, the firm’s services may be highly integrated into their own operations. This provides Sage with a significant amount of pricing power, thereby allowing it to deliver an improved financial performance even during periods of slower economic growth when winning new customers is naturally more challenging.

Separately, the company has a sound financial position through which to overcome periods of economic difficulty. Its net debt-to-equity ratio, for example, is just 40%, while it was able to service debt interest payments over 14 times in its latest financial year.

A fair price

An attractive business model means that Sage warrants a relatively high valuation. Even after recording a share price fall of 13% since the start of the year, though, it still trades on a price/earnings (PE) ratio of around 32. This is significantly greater than the ratings of many FTSE 100 members and may initially appear to suggest the stock is overvalued.

However, when the company’s prospective double-digit earnings growth rate is taken into account, its valuation begins to appear more attractive. Its market valuation becomes even more palatable when the potential for an improving operating environment is factored in. Therefore, on a long-term view, the stock appears to offer a favourable risk/reward opportunity as strong economic growth provides a tailwind for its financial performance.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.