Utilities Sector Rating: Neutral
The Utilities sector has tended to perform relatively better when concerns about slowing economic growth resurface, and to underperform when those worries fade. That’s partly because of the sector’s traditional defensive nature and steady revenues—people need water, gas and electric services during all phases of the business cycle.
Recent signs of peaking economic growth provide a relative tailwind for this defensive sector—particularly as market volatility rises. However, expectations for higher short- and long-term interest rates somewhat counterbalance the defensive attributes. It typically takes sharply slower economic growth for this sector to sustainably outperform—which is when the low interest rates typically provide cheap funding for the large capital expenditures required in this industry.
There could be significant government funding to Utilities as part of clean-energy initiatives that would benefit the sector’s profit outlook—depending on the extent of new regulations, which also could increase costs.
The Russian invasion of Ukraine in late February, and the ongoing political response, has clouded our outlook on equity sectors. Due to the unprecedented and volatile series of events, the economic and market landscape has become highly uncertain.
Until there is more clarity on how the sharp rise in commodity prices, tightening of financial conditions, and likely Federal Reserve interest rate hikes might impact the economy and underlying fundamentals that drive relative sector performance, we think it’s prudent to maintain sector allocations that are in line with the overall market.
Positives for the sector:
- Generally stable revenues and defensive characteristics are tailwinds amid signs of peaking economic growth.
- Price momentum has improved
- Investors often turn to utilities for dividend income when prevailing interest rates are low
- Low yields provide low funding costs for this capital-intensive sector
Negatives for the sector:
- Interest rates are expected to continue to increase, which counterbalances the sector’s defensive characteristics
- Weakening balance sheets with rise in debt and negative free cash flow
- Unattractive valuations
Risks for the sector:
- Uncertainty regarding potential clean-energy legislative funding
- Much higher interest rates due to a continued rise in inflation
What do the ratings mean?
The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market*
- Neutral: no current view on likely relative performance
* As represented by the S&P 500 index
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