Trading Strategies: expect appeal of this cyclical share to grow

Predicting when interest rates will start to fall has become something of a national obsession. Indeed, many investors are devoting significant amounts of time trying to estimate when the Bank of England will begin its dovish pivot.

With annual inflation having unexpectedly risen by 10 basis points to 4% in December, the chances of an interest rate cut at the Monetary Policy Committee’s (MPC) first meeting of 2024 on 1 February now seem slim. Investors who previously anticipated that Bank Rate would begin its descent on that date have shifted their forecasts so that they expect a spring, or even summer, cut to mark the start of a period of looser monetary policy.

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Second-guessing policymaker reactions

Of course, interest rate cuts are almost wholly dependent on when inflation is deemed by policymakers to no longer be problematic. While the Bank of England could wait until the annual rate of price rises falls to its 2% target before cutting rates, it may decide to begin the process of monetary easing before then due to the existence of time lags. This is where the effects of interest rate changes take time, usually well in excess of six months, to filter through to the economy’s performance.

So, investors need to accurately estimate how quickly inflation will fall over a relatively short timeframe, which is impossible due to the wide range of economic and geopolitical factors that can affect price changes. They also need to somehow second-guess how the MPC will react to it. After all, policymakers may play it safe and ensure that inflation is stamped out before worrying about weak economic growth or a recession. Or they may give in to growing pressure from business leaders and other vested interests to begin long-awaited rate cuts much earlier.

A more logical approach

Due to the great challenges involved in accurately forecasting inflation and interest rates, it is a wonder why investors spend so much time trying to do it. Certainly, if they guess correctly, they could time a short-term equity market surge as investor sentiment improves. However, there is a good chance they will be unsuccessful predicting the unpredictable. And it will take many months for the full effect of rate cuts to positively impact consumer spending and the economy’s growth rate.

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Therefore, a more logical approach is to anticipate that inflation and interest rates will both fall, but to spend time unearthing those companies best positioned to capitalise on it. Although a slower pace of price rises, a more accommodative monetary policy and a faster-growing economy are likely to positively impact the vast majority of firms, some are undoubtedly more sensitive to such changes than others.

The appeal of cyclical companies

Cyclical stocks could prove to be among the strongest performers over the coming months. Not only are their financial performances closely linked to the economy’s growth rate, and therefore highly likely to benefit from its improved outlook, their valuations are extremely appealing in many cases. They provide wide margins of safety that sufficiently compensate investors for the ongoing uncertainty regarding inflation, monetary policy and GDP growth, as well as offer scope for capital growth over the long run.

In some cases, a prolonged period of economic difficulty has severely weakened their financial standing. Other firms, though, have solid balance sheets with limited, or even no, debt and strong competitive positions that further reduce overall risk. Buying a wide range of such companies now, while they remain undervalued, could prove to be a highly worthwhile decision as interest rate falls ultimately shift from being on the horizon to a reality.

Improving operating conditions

Housebuilder Persimmon (LSE:PSN), for example, is well placed to benefit from falling inflation, rate cuts and an improving economic growth rate. An end to rampant inflation should ease cost rises that have contributed to a squeeze on the firm’s profit margins. In the first half of the 2023 financial year, for instance, the company’s operating profit margin declined by 13 percentage points year-on-year to 14% as rapidly rising material costs proved difficult to mitigate.

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Falling inflation will also ease the pressure on consumer disposable incomes, which have suffered due to wage growth failing to keep pace with price rises. This should prompt higher demand for new homes, with lower interest rates also set to make property purchases more affordable as mortgage rates gradually fall. And with monetary policy easing set to positively catalyse the economy’s growth rate, investor sentiment towards housebuilders is likely to significantly improve as the sector’s profits rise.

Sound fundamentals

Source: SharePad on 29 January 2024.

In the meantime, the company’s solid fundamentals mean it is well placed to overcome temporary economic challenges. The firm’s half-year results showed that it had a net cash position of £357 million, while the housebuilding industry’s relatively high barriers to entry provide a degree of stability to sector incumbents. Persimmon’s land bank, which totals 82,200 plots, means it has several years’ worth of land available as a result of new home completions amounting to less than 10,000 in 2023.

In terms of industry supply, the number of new homes being built has consistently failed to keep pace with demand. In the decade to 2020, for example, an average of 168,000 new homes were completed each year across the UK. Between 2020 and 2030, the Office for National Statistics (ONS) forecasts that the UK’s population will rise by 210,000 per year. Although not all individuals will require their own home, the figures suggest that the current imbalance between demand and supply is unlikely to dramatically ease. This could provide attractive operating conditions for housebuilders, with a scarcity of supply relative to growing demand as interest rates falls drive house prices higher.

Capital growth potential

Clearly, Persimmon faces several ongoing risks that could negatively affect its financial and share price performance. Political risk remains elevated, with an upcoming general election having the potential to result in planning reforms that could weaken the competitive position of sector incumbents.

There may also be further costs associated with cladding that could dilute profitability over the coming years, while the company’s share price rise of 22% over the past six months could cause some investors to feel that lower inflation, falling interest rates and an improving economic outlook have already been factored in by the stock market.

However, the company’s valuation suggests that it offers a wide margin of safety which fully compensates investors for ongoing risks, while providing scope for further capital growth.

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For example, Persimmon’s shares trade on a price-to-book ratio of 1.4. And while their forward price/earnings ratio is a rather rich 17.8, the company’s new home completions fell by a third in the 2023 financial year amid a tough operating environment. As a new era of lower inflation, falling rates and a stronger economy emerges, the firm’s profitability is likely to move significantly higher as per other cyclical companies.

Indeed, purchasing stocks that stand to gain the most from an evolving economic outlook, such as Persimmon, could prove to be a prudent move. Since the precise timing of improved operating conditions remains a known unknown due to the un-forecastable nature of inflation and interest rates, simply buying fundamentally sound firms that trade at attractive prices for the long term seems to be the most logical investment strategy currently available.

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