This year’s stock market turbulence has claimed another victim: utilities. What has gone wrong with the sector widely deemed safe from economic uncertainty?
Utilities had been relatively sheltered from the stock market downturn earlier this year, even as financials, industrials, tech stocks and consumer discretionary companies were clobbered over concerns about an economic slowdown or recession.
That’s now changing.
Canadian utilities have the dubious distinction of being the worst-performing sector within the S&P/TSX Composite Index over the past month. The group of stocks, which includes Fortis Inc. FTS-T, Emera Inc. EMA-T and Hydro One Ltd. H-T, is down 16 per cent over this period.
By comparison, the broader index has fallen just 6.5 per cent over the past month. Canadian financials, which are far more economically sensitive, have fallen just 6.3 per cent, and consumer discretionary stocks have fallen just 4.3 per cent, after bigger declines earlier this year.
It’s a similar story among U.S. stocks. Utilities have fallen 18 per cent over the past month, which is far worse than the 8.4-per-cent decline for the S&P 500 Index and the worst of all sectors over this period.
“The sector has underperformed the S&P 500 by about 12 percentage points over the past three weeks, despite no changes to the fundamental outlook. Our best explanation is that this was a catch-up trade,” said Andrew Weisel and Robert Hope, analysts at Bank of Nova Scotia, in a note this week.
Utilities had been outperforming the broader market for much of this year. While the S&P 500 in May was already down about 20 per cent, stocks such as Fortis, Emera and Hydro One were trading near record highs.
The reason: The sector looked safe at a time when economic uncertainty was weighing on more economically sensitive areas of the market.
But the popularity of utilities left the sector’s valuations looking stretched.
Based on their price-to-earnings ratios, U.S. and Canadian utilities were trading at a premium of 25 to 30 per cent above the broader market in the summer, according to the Scotiabank analysts.
As well, dividend yields shrank as stock prices rose. In the case of Fortis, the yield was 3.5 per cent as recently as August, down from about 4 per cent in early 2021.
Low yields may have looked palatable in the summer, as investors anticipated that central banks were perhaps nearing the end of their interest rate-hiking campaigns. But stubbornly high inflation and hawkish comments from the U.S. Federal Reserve since then have sent bond yields to new multiyear highs.
The yield on the 10-year U.S. Treasury bond rose from about 2.6 per cent in the summer to more than 4 per cent this week, diminishing the appeal of some dividends. The Government of Canada 10-year bond is yielding more than 3.5 per cent.
“Higher interest rates imply higher competition from alternatives, which can cause asset allocation to rotate from equities into fixed income,” said Robert Catellier, an analyst at CIBC World Markets, in a note this week.
The good news is that the sharp decline in utilities over the past month has made the sector more attractive.
Algonquin Power and Utilities Corp. has a dividend yield of more than 6.8 per cent after its share price slid more than 18 per cent since mid-September. Hydro One’s yield has risen to 3.5 per cent.
And Fortis shares now yield 4.4 per cent, which is more than bond yields.
“Even if rates go up, we still feel that we have a bit of a cushion there,” said Cory O’Krainetz, an analyst at Odlum Brown, the Vancouver-based investment management firm.
He added that regular dividend increases enhance the appeal of utilities, while the trend toward electrification – which includes a rising number of electric vehicles – should boost the sector’s growth profile.
Despite their recent slump, utilities also continue to hold some appeal for their ability to withstand economic downturns at a time when the International Monetary Fund is warning that “the worst is yet to come” in 2023.
New York-based Richard Bernstein Advisors argued recently that economically defensive sectors, including utilities, tend to outperform the market when corporate profits are decelerating, which the money manager expects over the next six to 12 months.
Utilities are struggling. But their recent decline makes them worth a closer look.