Investors turned to defensive utilities as the trade war intensified yesterday after President Donald Trump announced 10% tariffs on another $300.0 billion worth of Chinese goods starting on September 1. Increased trade war tensions sent broader market indexes tumbling, with the Dow Jones Industrial Average and the S&P 500 plunging approximately 1% each. The Utilities Select Sector SPDR ETF (XLU), the representative of the country’s top utility stocks, actually gained 1%.
Another rate cut in the cards?
The interest-rate-sensitive utilities sector didn’t celebrate the Fed’s rate cut on July 31 largely because the Fed hinted at no more cuts this year. However, renewed trade war tensions have dramatically increased the chances of another rate cut in September. According to the CME FedWatch Tool, traders are pricing in more than an 86% probability of another quarter-point cut at the Fed’s next meeting.
The Fed’s quarter-point rate cut this week sent Treasury yields tumbling to multiyear lows. The benchmark ten-year Treasury yield fell to 1.86% on August 1—close to the level it touched in November 2016. More concerningly, the yield on the three-month Treasury bill stayed relatively strong and closed at 2.09%. The spread between the two widened significantly this week and remained inverted. The inverted yield curve shows investors’ nervousness and deteriorating confidence in the economy over the long term. Investors typically turn to defensive sectors such as utilities amid growing uncertainty.
Trade war puts utilities in focus
Renewables giant NextEra Energy (NEE) stock rose 1.5%, while top regulated utility Duke Energy (DUK) rose almost 1% on August 1. Southern Company (SO) and Dominion Energy (D) soared 1.4% and 2.2%, respectively. Southern Company is the top gainer among the biggest utilities this year. It’s surged approximately 30% YTD (year-to-date), and it hit a new all-time high yesterday. Investment research company CFRA raised SO’s target price by $4.0 to $60.0 with a “buy” rating on August 1. JPMorgan Chase raised Dominion Energy’s target price from $77.0 to $78.0. Credit Suisse cut D’s target price from $83.0 to $82.0. It raised its rating from a “neutral” to an “outperform.”
Top utilities could continue to benefit from the increased uncertainty in the broader markets driven by the trade war—just as they’ve done more or less throughout the year. They’re up 14%, while the broader markets have gained 18% YTD.
Utilities continue to look financially sound largely due to their stable earnings profiles. Their targeted earnings growth of approximately 4%–5% annually for the next few years looks achievable, which might support similar dividend growth. Investors mainly shift to utilities due to their stable dividend payments and steady stock price movements. The Utilities Select Sector SPDR ETF (XLU) currently offers a dividend yield of 3.1%, higher than the broader market’s yield. However, top utility stocks such as Southern Company and Dominion Energy yield 4.4% and 5%, respectively—far higher than the peer average.
However, investors can’t bothered when it comes to utilities’ current valuations. They look to be trading at a large premium considering historical trends. You can learn more about the top utilities’ valuations in Not All Utility Stocks Are Overpriced.