How can utility stocks benefit if interest rates start to fall?

Many consider utilities a good defensive sector, but they are struggling in the current high interest rate environment. Argus Research analyst Marie Ferguson tells MoneyTalk’s Greg Bonnell why the outlook for the sector could change. If interest rates start to fall later this year.

Greg Bonnell: Interest-rate sensitive sectors such as utilities have suffered recently amid central bank hiking cycles. But with many expecting a rate cut this year, could things turn around for the sector? Mary Ferguson, an analyst at Argus Research, joins us now to discuss. Mary, it’s great to have you on the program.

Marie Ferguson: thank you for the invitation.

Greg Bonnell: So, let’s talk about utility space. We have a lot to go into here. First, let’s talk about the current economy. Are utility stocks considered: Would you make a defensive investment given what we are going through?

Marie Ferguson: yes. Historically, they have been considered defensive stocks. That means you’ll get more stable returns and consistent returns during periods when the economy is weak and markets are down. Defensive stocks are typically associated with well-known companies that provide goods and services that consumers need, regardless of their spending. So utilities fit the bill.

Another reason utilities are often traded as defensive stocks is because they are regulated. Therefore, most public utilities are highly regulated to maintain stability and typically have annual growth rates of around 3 to 5 percent. Regulators don’t just set electricity and natural gas rates. They actually work with the utility company to set rates that help the utility meet its revenue requirements for the year.

Regulators also oversee balance sheet items. They overlook debt ceiling ratios and set return on equity for capital investments. Therefore, utilities are known to have slightly lower risk and more moderate returns on stocks. But the beta level is also low. And they also generally provide stable dividend income, often significant qualified dividends, which are taxed at lower long-term capital gains rates than other non-normal income.

This may appeal to certain investors who are willing to accept the total return and dividend contribution of stock growth. Interesting. Currently, the average dividend yield for the S&P 500 is about 1.6%. The average dividend yield for utilities is 4%. So if we’re looking at 2% to 3% earnings growth, stable growth, defensive stocks, we’re looking at 4% earnings growth.

So not all utilities pay the same or increase their dividends the same. However, it is generally very stable. And dividends are rarely suspended. So I’d like to point out, for example, that Duke Energy in the utilities sector has been paying dividends for 99 years without missing a single year. Con Ed, a New York-area utility, has been raising its annual rates for 50 consecutive years. So a typical interest rate increase is 2-3%. But on our sector and equity side cover, we expect to see a rate increase closer to 7% or 8% this year. For example, Nextera and Wisconsin Energy expect dividend growth rates to be much higher than their peers.

Greg Bonnell: So we’ve got a good basis for why investors are looking at the utilities space as part of their portfolios. So what does it mean to say that utilities are interest rate sensitive? Because obviously interest rates are pretty much all we’ve been talking about for the last year and a half.

Marie Ferguson: This is a well-followed and fairly proven historical trend that the prices of utility stocks decline during periods of rising interest rates or prolonged periods of high interest rates. The reason is that when interest rates rise, large institutional investors leave the stock market, sell stocks, and move to the bond market. Therefore, even if interest rates rise, stock prices may perform poorly. However, on the contrary, the dividend yield also increases.

Therefore, when interest rates are high, stock prices often fall. And interested investors can follow the timing. It can provide you with an opportunity to enter the field.

As for the benchmark, I would like to point out that what the sector typically uses to measure interest rates is not actually mortgage rates, but the 10-year Treasury yield. So it’s hovering around 4.3%. So we’re roughly equal to the dividend yield of the sector.

Greg Bonnell: And we’re hoping for a rate cut. Yes?

Marie Ferguson: Better performance. sorry?

Greg Bonnell: What I said is that there is an expectation that the Fed will cut interest rates at some point this year. It’s still early in the year. I think the market is a bit impatient. But there is still an expectation that we will get these cuts. So what do you expect from the utility in terms of revenue this year?

Marie Ferguson: great. Well, I want to tell you what we are looking forward to. Almost every economist on the street seems to expect interest rates to ease at some point in 2024. The tick will be adjusted downward in the second half of 2024 and will continue to ease in 2025. So, with interest rates falling, I’d like to point out some historical facts to substantiate this theory that now could be a good time to enter the utilities sector.

So since 2007 we have had about five interest rate periods. Treasury yields and interest rates continued to fall. In 2011, when rates were falling, utilities were the best performing sector.

In 2014, when Treasury yields were falling, utilities were the second-best sector. And in 2018, it was also the second-best performing sector as rates fell. Conversely, rates increased from 2020 to 2023 and utilities ranked in the bottom five.

Greg Bonnell: So that’s a good historical context for that. Clearly, if interest rates are cut this year, as economists are predicting, we will start to see stock moves. What about actual profits? I mean, utilities are also kind of a capital intensive industry. And, well, you have to borrow money, right? Like anyone else.

Marie Ferguson: They have to borrow. Interest rate pressure caused a headwind to performance. We are making some generalizations about the sector. When the economy is weaker, stocks tend to follow and trade on interest rate news.

As the economy improves, we may see stronger, larger companies begin to trade on news of earnings growth and dividend increases. Very commonly, customer growth adds to revenue. New asset development adds to revenues, while regulation increases energy prices and cost savings add to profits. So what will the revenue be in 2024? I think we need to look at two things that happened.

So energy prices have soared in 2022. Wholesale electricity costs were high across the country. Natural gas prices were high. We were watching. My benchmark is the Henry Hub spot price. We have seen prices above $5 per million BTU throughout the year. We have seen prices as high as 8 during the summer. The price is expected to approach $3 in 2024 and 2025.

We do not expect natural gas prices to rise and approach $5 until 2025. This will result in cost savings. That will generate revenue. And another thing is the weather.

Temperatures at most utility facilities in the United States have been fairly mild. These are the mildest temperatures in over a decade. So we’ve seen revenue decline as usual. You’ll see 3%, 4% within a quarter. We were seeing 8%, 9%, 10%, even 15%, 20%. So the good news is that most weather forecasts say we will return to normal weather by 2024. So I think you can expect to see significant revenue growth in the first and third quarters for our utility. And that’s from a favorable comparison last year when they suffered so much.

original post