It hasn’t been a great year for investors to own stocks in the utility sector — the worst-performing part of the U.S. stock market so far in 2023 — but that could be coming to an end.
The S&P 500 Utilities Sector XX:SP500.55 held steady in September as a series of mixed economic data and fears of higher interest rates roiled financial markets, especially technology stocks. The utilities sector is up more than 3% so far in September and is by far the best performing group in the S&P 500, behind the energy sector XX:SP500.10,
according to FactSet data.
The utilities sector has also outperformed the information technology sector XX:SP500.45,
It fell 4.3% this month, by the largest margin since December 2022, according to Dow Jones Market Data.
“Utilities are very oversold right now,” said David Wagner, portfolio manager at Aptus Capital Advisors. “It seems like, given this oversold nature, the elastic has been stretched so far in one direction that you always have to be on the lookout for some sort of abrupt twist to the script.”
Utilities took a big hit earlier this year when higher interest rates made the sector less attractive compared to government bonds and money market funds.
Unlike high-growth technology stocks, utilities are often considered dividend income or defensive investments, especially during economic downturns or recessions. The companies that provide electricity, water and gas services tend to offer investors stable dividends and less volatility compared to the stock market as a whole.
The utilities sector is expected to pay a dividend yield of 3.3% this year, more than twice the S&P 500 SPX’s 1.6%,
but well below the 4.321% yield on the 10-year Treasury note BX:TMUBMUSD10Y and the 5.03% yield on the 2-year Treasury note BX:TMUBMUSD02Y,
according to FactSet data.
“It’s a normal connotation that when rates rise, utilities tend to underperform, and it’s clear that utilities tend to be a defensive, rate-sensitive sector,” Wagner told MarketWatch in a phone interview. “During a risk-on rally [this year]Utilities underperformed, so you’ve had a perfect storm for utility underperformance this year.”
That’s why investors could take advantage of the utility sector that is “already cheap” compared to tech companies that are typically considered risky investments but are now among the most overvalued after an artificial intelligence-driven rally earlier this summer, Irene Tunkel said . chief US equity strategist at BCA Research.
The S&P 500 Utilities sector trades at 17.4 times estimated earnings for the next twelve months, while the broader S&P 500 trades at 19.4 times expected earnings and the S&P 500 Information Technology Sector trades at 27.8 times expected earnings for the same sector . according to FactSet data.
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However, market analysts think an “abrupt pullback” in utility stocks could also signal some “risk-off” trades or deeper concerns about the US economy.
“The consensus is that yields will fall because they have already peaked,” Tunkel told MarketWatch by phone on Friday. She said economic growth will slow if there are no “surprises” that moved markets in 2023, and that the “economic surprise trade” will end.
“A lot of people are now looking at different sectors because they think rates will fall because economic growth has been too slow – they’re actually looking for defensive measures,” Tunkel said.
Morgan Stanley strategists predict that 10-year government bond yields will fall to 3.35% in the second quarter of 2024 in the base case. They said the market is vulnerable to both a slowdown in growth and a cooling of inflation amid healthy growth – two outcomes that investors appear unprepared for.
“This could support utility performance in the coming quarters, given the correlation between utilities and interest rate trends,” said David Arcaro, executive director of equity research at Morgan Stanley. “We also think utility valuations are cheap relative to the S&P, compared to the past decade on an absolute basis, and are in line with the long-term relationship relative to bond yields, so there could be valuation support over this time frame. ” (See the table below)
SOURCE: MORGAN STANLEY RESEARCH, BLOOMBERG
Major Utilities Catalysts for the End of the Year
There are other catalysts that Morgan Stanley strategists expect will boost utility stock performance in the near term.
Several utilities sector stocks “have meaningful regulatory decisions this year” related to project approvals or settlements in electricity rate cases, Arcaro and his team said in a Thursday note.
For example, the PPL of the PPL Corporation,
The plan to replace 1,500 megawatts of aging coal generation with a cleaner energy mix in Kentucky by 2028 seeks approval from the Kentucky Public Service Commission. A decision is expected by Nov. 6, the company said on its second-quarter earnings call. Shares of PPL rose nearly 3% in September.
“We see several opportunities where these regulatory processes have acted as an equity overhang, and where we see a high probability of success and positive revaluation as regulatory decisions are made,” Arcaro and his team said.
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Other policy support includes guidance from the U.S. Treasury Department on eligibility for the green hydrogen production tax credit in the September to October period, Morgan Stanley strategists said. The PTC is included in President Biden’s 2022 Inflation Reduction Act, which provides funding, programs and incentives to companies and individuals in the largest U.S. climate change effort to date, and allows taxpayers to share a percentage of the cost of renewable energy systems from their expenses. federal taxes.
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Meanwhile, Arcaro and his team see demand for renewables accelerating for some utilities, such as NextEra Energy Inc.
and AES Corporation AES,
but they remain cautious about short-term tail risks such as fire and hurricanes.
US stocks closed lower on Friday to cap a losing week for the S&P 500 and Nasdaq Composite COMP.
The S&P 500 fell 0.2% and the Nasdaq fell 0.4% for the week, while the Dow Jones Industrial Average DJIA was 0.1% higher, according to FactSet data.