Utilities sector overview
A growing U.S. economy could create a headwind for the utilities sector, the potential for rising inflation could lead to higher interest rates, reducing the attractiveness of dividend-paying utilities companies.
Market outlook for the utilities sector
The utility sector had a period of better performance recently, with investors apparently again seeking income and perceived “safety” of the group. We believed this was short lived as rising inflationary pressures should push fixed income yields higher again, lessening the attractiveness of the utilities sector, and the sector’s performance has suffered recently. We have warned against using equity dividends as a proxy for bond yield income, as the risk characteristics are much different. We believe investors should refrain from rushing into the utilities sector, as we could see a repeat of the sharp reversals we’ve seen recently.
We think U.S. economic data will continue to show improvement, prompting investors to move into more cyclical areas of the market, away from the traditionally defensive utilities sector. Inflation readings have perked up somewhat, with the Consumer Price Index moving up to a 2.1% year-over-year rise, not extreme, certainly, but the trend is higher, while wages also are moving higher, with the Labor Department’s average hourly earnings number posting a 2.7% year-over-year gain. The result has been fixed income rates moving higher, a trend we believe will generally continue, leading to a movement away from utilities.
In spite of the recent carnage, some of the fundamentals in the utilities sector have perked up, with BCA Research reporting that electricity production is rising, while their valuation indicator has corrected out of overvalued territory. These positives don’t overcome the negatives in our minds, as valuations haven’t gotten to undervalued levels and positive global PMIs, such as we’ve seen, have historically tended to lead to utilities sector underperformance.
The recent spike in volatility may have encouraged investors to seek the perceived safety of the utilities sector, but we didn’t and don’t believe that’s the right move. A growing economy and rising interest rates don’t make for a good combination for utilities performance in our mind and we believe underperformance will likely continue.
Factors that may affect the utilities sector
Positive factors for the utilities sector include:
- Improvement in housing: An improving housing market could lead to higher electricity demand in developing areas, and we're seeing signs that may be occurring as electricity production is growing again.
- Attractive dividends: Dividend-paying stocks could remain attractive compared to relatively low yields on conservative fixed-income products. And should economic prospects decline, defensive, dividend-paying stocks could become even more attractive.
Negative factors for the utilities sector include:
- High fixed costs: Capacity growth has been rising, which has been a sign of underperformance for the sector in the past.
- Accelerating economic growth: This would likely make the defensive utilities sector less attractive.
- Rising interest rates: This would make the dividend-paying utilities sector less competitive with fixed income investments. Additionally, relatively high debt ratios in the sector could be problematic.
Clients can see our top-rated stocks in the utilities sector.
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