The most reliable sector of the stock market has been anything but this week, as investors flee utilities stocks in favor of better yields and less risk in Treasurys.
The S&P 500 Utilities sector is down 21% this year, on track for its first drop of more than 5% since 2008 and significantly underperforming the broader index’s 11% gain. That includes a 12% decline in just the last two weeks as Treasury yields have spiked, with the Federal Reserve indicating that it will raise interest rates one more time this year. Friday’s healthy jobs report showing the U.S. added 336,000 to payrolls in September, double what economists were expecting, was another signal that the Fed will keep raising. The 10-year Treasury yield sits at 4.8% and the 2-year yield is over 5.1%, both hitting 16-year highs.
Making matters worse for utilities, NextEra Energy Partners (NEP), a publicly traded subsidiary of NextEra Energy (NEE), the largest company by market cap in the sector at $96 billion, slashed its target dividend growth rate through at least 2026 to 6%, down from 12% to 15%. NEP’s stock has cratered 58% in the last two weeks, while the parent company is down 30% in that span.
“We’ve had the confluence of a rapid rise in rates these last two weeks, the bellwether of the group cutting the dividend growth rate of its financing vehicle, plus utilities already went into this headache pretty rich on a yield basis,” says Mizuho analyst Anthony Crowdell. “All three of those have manifested themselves in the last week and a half.”
Investors in utilities companies, which provide electricity and water to customers, generally sacrifice the upside potential of more risky sectors like technology in favor of dependable returns and high dividend yields. The average yield for the sector now sits at about 4%, compared with the S&P 500’s overall dividend yield of 1.6%.
For the last 15 years, Crowdell says the sector’s dividend yield has on average sat about 1.05 percentage points higher than the 10-year Treasury yield, rewarding investors for the added risk of owning the utility, but this year’s moves in interest rates have flipped that balance on its head. Yield-hungry investors haven’t hesitated to sell utilities and buy more attractive fixed-income assets, and analysts don’t expect the pain to be over until interest rates retreat or equities decline more to push their yields higher. Investment grade corporate bonds, like iShares iBoxx Investment Grade Corporate ETF [LQD] currently yield around 6%, and iShares Broad USD High Yield Corporate Bond ETF [USHY] is yielding 9%.
“We can’t recommend buying until the macro picture stabilizes, which may take some time,” says Scotiabank utilities analyst Andrew Weisel.
Utilities haven’t lagged behind the rest of the market so much since 1999, when the sector fell 9% while the S&P 500 rose 20% fueled by the final chapters of the dotcom bubble inflating. That was a good time to buy in hindsight–utilities gained 57% in 2000, compared with the S&P 500’s 9% drop that year, while bond yields fell and investors fled to safety from crumbling tech stocks.
Utilities have also outperformed in the market’s only two down years since 2008, with a 4.1% gain in 2008 and a 1.6% increase last year. When the group fell 29% in 2008, its most recent sharp decline prior to this year, it still wasn’t as punishing as the broader market’s 37% crash.
But the industry is in some respects entering uncharted territory now, navigating more severe weather threats than ever before. Hawaiian Electric Industries (HE) fell 63% in August following allegations that its power lines which were knocked down or damaged by strong winds fueled the Maui wildfires, prompting lawsuits from Maui County and investors.
“If you own a group for a 10% [total] return but then you see the stock went down 30% because of wildfires, you kind of question why you actually own this investment,” says BMO Capital Markets analyst James Thalacker. “It’s not just wildfires, too. You’ve seen some areas with increased severe weather, 80-90 mile an hour horizontal winds or winter storms that the system wasn’t set up to deal with.”
High interest rates are also increasing borrowing costs for capital-intensive renewable energy projects, making analysts favor companies with strong balance sheets to be the sector’s outperformers. Crowdell and Weisel recommend DTE Energy (DTE) and CMS Energy (CMS), competing Michigan-based utilities. Both are down around 20% this year, in line with their peers, but are continuing to generate reliable sales and earnings growth, and Crowdell cites Michigan’s friendly regulatory environment for these companies. CMS is trading at a P/E multiple of 20.7, more expensive than most stocks in the sector, with DTE at 14.7 times earnings. Thalacker concurs that CMS is one of the highest-quality businesses in the sector along with Wisconsin-based Alliant Energy (LNT) and Texas’ CenterPoint Energy (CNP).
“When you look at the macro risks, inflation, higher interest rates, we think some companies are going to struggle to hit their earnings growth targets,” Crowdell says. “You want to play quality stocks even though you’re paying a higher multiple, because they’re going to be able to navigate these challenges.”
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