Sector Screener: rate cuts a catalyst for two FTSE 100 stocks

The era of interest rate cuts has finally arrived. After the European Central Bank (ECB) reduced borrowing costs by 25 basis points in June, the Bank of England has followed suit by cutting the bank rate from 5.25% to 5% at its latest meeting.

While the Federal Reserve has thus far failed to embrace a more dovish stance, it is nevertheless widely expected to cut interest rates from their current level of 5.25-5.5% to 4.1% by the end of next year.

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Of course, interest rate cuts are excellent news for the economy’s prospects. All else being equal, they should make consumers less likely to save and more likely to spend. A looser monetary policy should also cut mortgage costs, thereby providing households with greater discretionary incomes that are likely to ultimately have a positive impact on the rate of GDP growth.

Potential beneficiaries

Companies that are set to benefit from an improving global economic outlook include those in the General Industrials sector. Its members are typically more cyclical than the average FTSE 350 stock and have therefore suffered to a relatively large extent from the world economy’s subdued performance over recent years. Indeed, while the FTSE 350 index has risen by around 7% since the start of 2022, the General Industrials sector has produced a return below 4% over the same period.

Now, though, its prospects are becoming increasingly upbeat as a period of sustained interest rate cuts across developed economies gradually takes hold. Indeed, the relative cyclicality of the sector is set to shift from being a liability to an asset. And while valuations in the sector have risen so far in 2024, as evidenced by an 8% return since the start of the year, investors can still purchase a range of high-quality companies at attractive prices.  

Source SharePad. Data as at 14 August 2024. Past performance is not a guide to future performance.

Source SharePad. Data as at 14 August 2024. Past performance is not a guide to future performance.

Short-term uncertainty

Clearly, interest rate cuts will take time to have their desired impact on the economy’s performance. In the meantime, the outlook for the world economy could realistically come under pressure. In the US, for example, the unemployment rate has risen over recent months and the latest manufacturing PMI reading showed a sharp fall. Even if interest rate cuts take place over the coming months, their full effect on economic growth is unlikely to become clear until next year at the very earliest.

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There is also uncertainty about the extent to which central banks can seek to stimulate the economy. Although inflation in the UK has fallen of late so that it is in line with the Bank of England’s target, in the eurozone it remains 60 basis points in excess of the ECB’s target. In the US, meanwhile, inflation is still 100 basis points above the Federal Reserve’s target. This means there could realistically be a period of slowing economic growth in the short run, caused by sticky inflation, that weighs on the performance of the General Industrials sector.

A disciplined approach

Investors in the sector should therefore remain disciplined, in terms of only purchasing companies that are capable of surviving a potentially challenging economic outlook in the short run. For example, firms that can easily cover their debt interest payments are less likely to struggle should a period of slower economic growth negatively affect their profitability. Similarly, companies that have a clear competitive advantage are likely to be less impacted by a tough industry outlook in the short run. They are also more likely to be in a strong position to capitalise on improving economic prospects in the long run.

Clearly, share prices in the General Industrials sector are set to be relatively volatile over the coming months. This, though, presents an opportunity rather than a threat to investors who can adopt a long-term approach. Although interest rate cuts may not happen as quickly as many investors would like, and their effects are set to be delayed, ultimately the world economy’s performance is highly likely to improve as a looser monetary policy is implemented. Given the relative cyclicality of General Industrials stocks, they are well placed to benefit and should, therefore, deliver FTSE 350 outperformance over the long run.

Past performance is not a guide to future performance.

Smiths Group

While operating conditions for companies in the General Industrials sector have been tough over recent years, Smiths Group (LSE:SMIN) has generated strong earnings growth. Over the past three years, for example, the engineering company’s earnings have risen at a compound annual growth rate of 25%. Despite this, its share price gain of 10% since the start of 2022 is only three percentage points greater than that of the wider FTSE 350 index over the same period.

Encouragingly, the firm’s latest quarterly update showed that revenue rose by around 6% on an organic basis. It is also on track to meet financial guidance for the full year, with sales expected to rise by 4-6% excluding the impact of acquisitions. Furthermore, it expects to deliver profit margin expansion this year. This suggests that it has a solid competitive position, with a double-digit return on equity providing further evidence of its capacity to outperform the wider industry over the long run.

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With a debt-to-equity ratio of 27% and net interest cover of 14, Smiths Group has the financial means to survive a period of potentially slowing global economic growth. Although its shares currently trade on a price/earnings (PE) ratio of around 17 in spite of their lacklustre performance over recent years, the company’s sound fundamentals mean it still offers good value for money.

Certainly, the firm’s share price is likely to be relatively volatile. But with the company having 70+ years of uninterrupted dividends, it has proved to be highly resilient despite experiencing a variety of economic challenges. As a result, it offers long-term investment appeal, with an improving global economic outlook set to catalyse its financial performance.

Mondi

Fellow General Industrials sector incumbent Mondi (LSE:MNDI) also offers long-term investment potential. The paper and packaging company’s recently released half-year results showed that it performed in line with expectations during the period. Although its earnings declined by 25% year-on-year, it is set to benefit from a period of lower inflation that puts less pressure on its profit margins. It also expects to feel the full effect of recent price rises in the second half of the current year, which should further support profitability in the near term.

In response to its challenging operating environment, the company’s shares have fallen by 18% since the start of the year. They are now down by 29% since the start of 2022, which represents a significant underperformance of the General Industrials sector’s 4% rise over the same period. Despite this, Mondi’s shares trade on a relatively rich PE ratio of around 16.

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The company’s sound fundamentals, though, suggest it offers good value for money. In its latest full year, for instance, return on equity amounted to 9% in spite of the firm having very modest debt levels. Indeed, its net debt-to-equity ratio amounted to just 7% last year, which highlights its capacity to overcome a tough operating environment in order to benefit from an improving industry outlook.

Clearly, Mondi’s recent financial performance has been disappointing. But with the company having a solid balance sheet, a sound strategy, as well as being set to benefit from a period of lower inflation and stronger economic growth, it offers capital growth potential over the coming years.

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