Utilities continued to trade strong while broader markets closed sharply down yesterday. The representative of top utility stocks, the Utilities Select Sector SPDR ETF (XLU), soared 1.8% as investors turned to defensives.
The S&P 500 (SPY) fell 0.7%, while the Dow Jones Industrial Average (DIA) tumbled more than 1% on September 3. Other defensive players such as REITs advanced 1%, while consumer staples rose 0.6% yesterday. The US imposed another round of tariffs on Chinese goods on September 1.
Recession fears grow
Wall Street took a tumble yesterday after increased tariffs on Chinese goods took effect over the weekend. To add to these woes, the ISM (Institute of Supply Management) showed that US manufacturing contracted in August. The ISM US manufacturing purchasing managers’ index decreased to 49.1% in August, its lowest level in the last three years.
A reading of above 50 indicates expansion, while one of below 50 indicates contraction. The contraction implied by the reading aggravated recession fears, which took a toll on the markets yesterday.
Safe-haven stocks have remained in the sweet spot amid market uncertainty this year. Utility stocks on average have surged almost 20% in 2019, while the S&P 500 is up about 16%.
Top utilities continue their upward march
Southern Company and NextEra Energy are some of the top-rallying stocks in the sector this year. Both have been consistently making all-time highs for the last few months. Including dividends, Southern Company has returned more than 40%, while NextEra Energy has returned 32% YTD (year-to-date).
Both of these stocks are trading in the overbought zone at the moment due to their recent strength. Trading in the overbought zone could mean that they’ll see a reversal in the short term.
Utilities offer a juicy dividend yield
Utilities have relatively high dividend-paying capabilities. XLU offers a dividend yield of 3%. In comparison, Southern Company stock is trading at a yield of 4.3%, while NextEra Energy yields 2.3%. Together, these two stocks make up almost 20% of XLU.
Utilities typically pay a higher portion of their earnings in the form of dividends to shareholders. In fact, that’s why they have higher dividend yields. In 2018, utilities’ average payout ratio was approximately 70%, higher than the broader market’s.
These defensives have beaten the broader market in the long term. XLU has returned 75% (including dividends), while the S&P 500 has returned 60% in the last five years. Utilities’ slow but stable earnings and dividend growth have contributed to their consistent performance.
The Fed’s much-awaited booster
Utilities are generally perceived as bond substitutes. Lower interest rates could make utility stocks more attractive than bonds. Also, lower debt-servicing costs led by lower rates could improve utilities’ profitability.
The benchmark Treasury yields recently fell to record lows. The yield curve inversion ignited recession fears. Trade war tensions also don’t seem to be easing off anytime soon. In such an environment, market players look to the Federal Reserve for help. The Fed lowered interest rates in July, marking its first rate cut in a decade.
Market participants expect more aggressive rate cuts from the Fed this year. The utilities sector, one of the most vulnerable sectors to interest rates, is expected to benefit from the probable interest rate cut. Interest rates and utility stocks generally trade opposite each other. According to CME’s FedWatch tool, traders expect a 90% probability of a quarter-point rate cut in the Fed’s upcoming September meeting.
Wells Fargo increased top utility stock NextEra Energy’s price target from $232.0 to $240.0 on September 3. It also raised Southern Company’s price target from $59.0 to $62.0. SunTrust Robinson Humphrey increased Southern Company’s price target to $59.0 yesterday.
The recent rally in utility stocks has made them more expensive given their historical trends. Their inflated valuations could be a significant hindrance to their upward movement from their current levels. To learn more about where these defensives might go from here, read Why Utility Stocks’ Upside Looks Capped from Here.