Trading Strategies: the outlook for Rolls-Royce shares

Gut instinct is likely to be telling many investors to sell equities at the moment. After all, the stock market faces a highly uncertain near-term future that could prompt heightened share price volatility.

For example, the full effects of a fast-paced rise in US interest rates remain unclear. Due to the existence of time lags, recent increases in the federal funds rate could yet prompt slower GDP growth, or even a recession, over the coming months. And since the Federal Reserve now believes that interest rates will need to remain higher for longer than previously anticipated, investors are beginning to accept that the central bank’s battle against high inflation is likely to be more protracted than initially expected.

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Sticky inflation is also likely to delay central bank plans to slash interest rates in the UK and Europe, where economic growth is already snail-paced. China’s economy, meanwhile, is spluttering, with expectations of a period of rampant growth following the end of its zero-Covid policy failing to fully materialise. These issues have led to recent global economic growth downgrades, with the International Monetary Fund (IMF) and OECD both now expecting the rate of world GDP expansion to slow in 2024.

In addition, investors face elevated uncertainty as a result of heightened geopolitical risks. The potential for conflict in the Middle East and Eastern Europe to broaden and deepen is unlikely to prompt improved investor sentiment and rising share prices over the short term.

Investment opportunities abound

However, the stock market’s history shows that periods of economic doom and gloom can provide stunning long-term buying opportunities. After all, elevated economic and geopolitical uncertainty generally prompts weaker investor sentiment that results in lower share prices. Investors are therefore able to purchase high-quality companies when they offer a wide margin of safety that may not be available during more benign periods.

And since the stock market has a consistent track record of producing new record highs even after experiencing the most challenging of circumstances, investors who use temporary market declines to buy stocks are likely to ultimately be rewarded.

An upbeat long-term future

The long-term outlook for equity markets also remains highly upbeat. While US interest rates are set to remain higher for longer, the Federal Reserve still thinks they will fall to 5.1% next year before dropping to 3.9% by the end of 2025. It anticipates that long-term interest rates will settle at around 2.5%, which bodes well for the global economy’s outlook and the stock market’s performance.

Indeed, demographic changes and productivity challenges across developed markets mean that interest rates are likely to fall towards pre-pandemic levels over the coming years, according to the IMF. This is likely to create operating conditions that are more conducive to profit growth and improved investor sentiment towards the stock market, as today’s increasingly en vogue assets, such as cash, lose their relative appeal.

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While China’s economy continues to stutter, it is nevertheless forecast to expand by 5.1% this year and 4.6% next year. Emerging economies as a group are expected to grow by 4% this year and next year, thereby continuing to provide UK-listed companies with opportunities to expand into new, fast-growing markets.

In the UK, GDP growth is forecast to increase from 0.3% this year to 0.8% next year as interest rates peak and inflation falls to 2% within 18 months, according to the Bank of England’s estimates. Therefore, domestically-focused stocks have a bright future as the current era of high inflation/rising interest rates draws to a close.

Furthermore, geopolitical risks are a constant “known unknown” for investors. History shows that their occurrence, and outcome, can never be accurately forecast. Nor can their impact on the economy or stock market ever be perfectly estimated ahead of time. Therefore, it may be prudent for investors to accept that share price volatility could rise in the short run, but avoid basing their decisions on the possible outcomes of ongoing geopolitical events due to their inherent unpredictability.

Strong fundamentals

As ever, selecting stocks that offer sound fundamentals is paramount to investment success. Solid balance sheets, clear competitive advantages and wide margins of safety help to reduce risk and boost long-term reward potential.

For instance, aerospace and defence company Rolls-Royce Holdings (LSE:RR.) is making encouraging progress in improving its financial position. While net debt stood at £5.2 billion in 2021, it declined to £3.3 billion at the end of last year due in part to £2 billion of asset disposals. A reduction in net debt has been further prioritised this year so that it stood at £2.8 billion at the time of the company’s half-year results in June. It also has access to £7.4 billion of liquidity, which includes cash of £2.9 billion, through which to navigate any short-term economic uncertainty.

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The firm’s resilience is also likely to be boosted by a greater focus on efficiency, as it seeks to become increasingly competitive versus sector peers. Following its half-year results, the company announced a reduction in the size of its workforce of 5-6% to cut costs and boost margins. This was undertaken alongside a change to its structure, with the overall aim being to create a more flexible and nimble business that can quickly adapt to changing industry trends.

Source: TradingView. Past performance is not a guide to future performance.

Improving industry prospects

The company’s half-year results showed a marked improvement in profitability and cash flow, with pre-tax profits and free cash flow moving to positive figures from negative levels recorded a year earlier. This prompted the company to raise full-year financial guidance, with earnings per share now expected to grow by 21% next year and by a further 22% in the 2025 financial year.

The company’s defence division, which currently accounts for 29% of revenue, is set to benefit from rising military spending that has been prompted by increased geopolitical risks. Indeed, while only seven out of 31 NATO members met a target to spend 2% of annual GDP on defence last year, eleven members are forecast to achieve the goal this year. Given heightened unrest in the Middle East and continued conflict in Ukraine, it seems likely that defence stocks will experience growing demand for their products and services over the coming years.

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The prospects for the firm’s civil aerospace division, which manufactures engines for commercial jets and contributes 45% of total revenue, are also improving. Global passenger traffic increased by 28% year-on-year in August and now stands at around 96% of pre-Covid levels. Passenger numbers are forecast to surpass 2019 levels next year, as the industry continues to recover from the effects of the pandemic. Higher passenger traffic numbers mean Rolls-Royce is set to experience greater demand for the engines it supplies, with its large engine order book recently showing growth for the first time since 2018, as well as higher demand for maintenance as engine flying hours increase.

Investors should watch closely for comments from Rolls’ popular CEO Tufan Erginbilgiç who gives a strategy update at a Capital Markets Day on 28 November.

While Rolls-Royce’s share price has more than doubled since the start of the year, it is down 1% in the past month. The deficit was 9% before this week’s price target upgrade to 270p by analysts at Barclays. However, the shares continue to offer value for money, since they trade on a forward price/earnings ratio of 21.9 using this year’s forecast earnings figure. Given that earnings growth in excess of 20% is expected to be delivered both next year and in 2025, considerable capital growth potential remains on offer.

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