The top utility stocks might continue to rise if the Fed delivers its much-awaited interest rate cut this week. According to CME’s FedWatch tool, traders expect more than a 78% probability of a quarter-point rate cut this week. Utility stocks generally move inversely to interest rates. Recently, the rate cut hopes have pulled the markets up. So far this year, the S&P 500 has risen more than 20%, while the utilities sector (XLU) has risen approximately 15%.
Top utility stocks
Utilities are usually seen as bond substitutes due to their stable dividend-paying abilities. Lower interest rates will likely result in lower debt servicing costs, which supports utilities’ profitability. Along with the probable rate cut this week, the Fed’s commentary about future rate cuts might drive utility stocks going forward.
According to CNBC, Janet Yellen, the former Fed chair, said that she supports a quarter-point interest rate cut due to low inflation and the weak global economy. If the Fed cuts rates this week, it will be the first interest rate cut in more than a decade.
Investors shift to defensives
The benchmark ten-year Treasury yield continues to trade lower compared to the three-month Treasury yield. The phenomenon is popularly known as an “inverted yield curve.” The inverted yield curve hints at an upcoming recession. The curve shows investors’ anxiety and declining confidence in the economy over the long term. Investors might turn to defensives, like utilities, amid growing uncertainty.
We expect Southern Company (SO) and Dominion Energy (D) to report their second-quarter earnings this week. Southern Company stock has beaten its peers this year. So far, the stock has gained more than 25%. Better-than-expected earnings and the expected rate cut might fuel Southern Company’s upward move in the short term. NextEra Energy (NEE) reported its second-quarter earnings last week. The company continued its superior growth in the second quarter. NextEra Energy’s adjusted earnings increased 13% in the second quarter compared to the second quarter of 2018.
Despite several supporting factors, utilities’ valuation is still a big concern. Broader utilities are trading at approximately 19x their forward earnings, which is way higher in historical terms. Broader markets are trading around 17x their forward earnings. Utility stocks might have gone too far in investors’ rush to move to defensives this year.
Utilities at large have returned more than 60%, including dividends, since the Fed started increasing interest rates in December 2015. Utilities have beaten broader markets during this period. Dividends play a big role in driving investors’ total returns. Currently, the Utilities ETF (XLU) yields 3.1%, which is higher than the broader markets. Southern Company and Dominion Energy are few top-yielding stocks among the biggest utilities. They yield 4.5% and 5.0%, respectively.
To learn more, read These Utilities Have Increased Dividends for 45+ Years.