Trading Strategies: the outlook for GSK and its dirt-cheap share price

When it comes to the stock market’s prospects, making assumptions is a dangerous game. After all, history shows that equity markets are frequently catalysed or corrected by events that few, if any, market participants are able to accurately foresee. For example, the ongoing period of rampant inflation was initially viewed as being a temporary phenomenon by central bankers who therefore belatedly raised interest rates.

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Currently, many investors are assuming that interest rates will fall considerably across developed markets in 2024. This is based on inflation declining at a brisk pace over the past year so that it stands at 3.1% in the US, 2.4% in the eurozone and 4.6% in the UK. With both the eurozone and UK economies failing to generate strong growth over recent months, and the full impact of interest rate rises on the US economy arguably yet to be fully felt due to time lags, a more accommodative monetary policy in 2024 is being taken as a given.

This standpoint has prompted a significant shift in investor sentiment. Having struggled over the summer months, stock markets have risen substantially in recent weeks. The FTSE 100 is up 4% since the end of October, while the S&P 500 has risen by 15% over the same period. This bullish sentiment may prove to be well founded, but it could easily end up being an oversimplification of what is a very uncertain period for the global economy.

Slow and steady interest rate cuts

Indeed, the Federal Reserve seems to be in no rush to slash interest rates. This is entirely understandable, since the US economy grew at an annualised rate of 5.2% in the third quarter. With the US unemployment rate falling by 20 basis points to 3.7% in November, there seems to be little need to cut interest rates to stimulate an already buoyant economy.

While time lags inevitably mean previous monetary policy tightening has not yet had its full impact, the Federal Funds Rate was only one percentage point lower in December 2022 than it is today. Therefore, it seems unlikely that a severe US economic slowdown which requires a significant programme of monetary policy easing will take place. As a result, the Federal Reserve expects interest rates to fall by just 0.8 percentage points next year.

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In the UK, inflation remains 2.6 percentage points above the Bank of England’s target. While the economy undoubtedly needs greater stimulus to post stronger growth figures, with it failing to expand in the third quarter, policymakers are somewhat hamstrung until the pace of annual price rises is substantially closer to 2%.

The eurozone, meanwhile, is arguably the outlier among the three regions/countries. Its economy is on the brink of recession, while inflation stands at just 2.4%. The European Central Bank (ECB), therefore, appears to have sufficient grounds to begin monetary policy easing in the near future. Even then, though, it may decide to remain cautious should its peers fail to become more dovish.

Managing expectations

If interest rates decline at a slower pace in 2024 than investors currently anticipate, the stock market could prove to be highly volatile. This in itself is not a reason to avoid shares. After all, interest rates in the US, UK and eurozone are very likely to fall over the coming years in response to productivity challenges and demographic changes. This is set to prompt a rising stock market that outperforms all other mainstream asset classes, which means now is likely to be a worthwhile time to buy shares on a long-term view.

However, investors should manage their expectations for stock market returns over the next year. Central banks will understandably be cautious after their recent, and ongoing, failure to meet inflation targets. And since that is their main focus, it would be unsurprising for them to concentrate on achieving it at the expense of economic growth.

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In such an environment, investors who continue to purchase fundamentally sound companies that trade at fair prices are likely to be in a strong position. Conversely, overpaying for stocks based on assumptions could prove to be a costly mistake during what is likely to be a bumpy transition from an era of high inflation and rising interest rates to a more modest pace of price rises and dovish monetary policy.

A favourable risk/reward opportunity

Source SharePad. Data as at 18 December 2023.

Pharmaceutical company GSK (LSE:GSK) remains a sound long-term purchase due to its solid fundamentals, low valuation and long-term growth potential. The company’s shares have edged 1% lower since the start of the year, even though its financial performance has been highly encouraging. Its shares now trade on a forward price/earnings (PE) ratio of just 9, which suggests they offer good value for money during an uncertain period for the wider stock market.

The firm’s latest quarterly results show it is making good progress, with revenue rising by 16% and earnings per share increasing by 17% (excluding the impact of declining Covid-19 solutions sales). This performance prompted the company to raise full-year guidance, with its bottom line now expected to grow by 17-20% versus a previous forecast of 14-17%. This represents a fast pace of growth compared with many, if not most, FTSE 100 stocks and suggests the stock’s low valuation will become increasingly difficult to justify.

GSK’s solid financial position means it has the capacity to invest heavily for future growth. Although its net gearing ratio of 140% may initially seem high, the firm’s net interest costs were covered a healthy 12 times by operating profits in the most recent quarter. This suggests it can easily afford its debt servicing costs, with its defensive business model providing stability compared with other more cyclical companies. In fact, its lack of dependence on the economic outlook means it could perform relatively well should the pace of interest rate cuts prove to be slower than investor expectations.

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Defensive characteristics, though, do not mean investors in GSK are compromising on long-term growth potential. The company increased the amount it spent on research and development (R&D) by 14% in the third quarter, with it now accounting for 18% of total sales. It plans to further raise R&D spending at a rate that is slightly below sales growth over the medium term. This increases its chances of producing blockbuster treatments that have a positive impact on sales and profitability over the coming years.

The firm currently has 86 projects in clinical development in what is a diversified pipeline. Its main focus is on infectious diseases, such as Hepatitis B, with an emerging oncology pipeline providing long-term growth potential as global demographic changes continue. Its solid financial position also means it can make acquisitions, such as the recent purchases of Affinivax and Sierra Oncology, to supplement its pipeline.

Clearly, ongoing uncertainty regarding Zantac, which is a discontinued heartburn drug that has been alleged to be linked to cancer, could continue to act as a drag on its share price. However, the market appears to have accounted for legal risks via the stock’s low valuation, which provides a wide margin of safety.

While investors should not assume GSK will deliver on its potential, its solid financial position, defensive attributes and a pipeline that has the capacity to catalyse earnings growth in the coming years mean its risk/reward ratio is highly appealing.

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