Inflation occurs when prices rise while money’s purchasing power decreases. It hurts consumers, but it doesn’t always hurt stocks. More properly, some industries are more resistant to inflation than others, but the utilities sector is rarely a safe haven from rising prices.
What happens to utilities when prices rise?
The main reason why people buy utility stocks is to get a high dividend yield. Interest rates on other yield-focused assets will climb if inflation rises. As a result, if interest rates rise significantly, utility stock share prices will normally fall, increasing the yield. Investors in utility stocks will continue to benefit from the dividends that drew them in the first place. However, as interest rates begin to rise, an investor should not be startled to see his utility companies’ share prices fall, only to see them settle once interest rates reach a new level of stability.
Do utilities fare well when interest rates rise?
After hiking short-term interest rates to their current range of 0.75 percent -1 percent in March, the Federal Reserve held them steady on May 3. After a seven-year period of near-zero interest rates following the global financial crisis, the Fed raised rates for the third time.
The Fed has yet to announce when it will raise rates again, but it is evident that we are in a rising interest rate environment. With higher interest rates on the horizon, investors may be tempted to steer clear of the capital-intensive, “interest rate sensitive” utility industry. Utility stock indexes, on the other hand, have kept up with or outperformed certain broader market indexes this year. The DJ Utility Average is up 5.7 percent year to date through March 31, 2017, compared to 4.6 percent for the DJIA and 5.5 percent for the S&P 500. A look at historical trends indicates that the interest rate stigma associated with utility equities is a myth.
Utilities are frequently viewed as lower-risk defensive investments with a strong cash flow and predictable dividends since they are regulated monopolies with mechanisms in place that provide for the recovery of costs as well as the recovery of revenue on new investments. Rising interest rates may have a greater impact on utilities than on other sectors since they make bonds more appealing to conservative investors looking for a return. Operating a utility has a high capital cost/debt ratio, which raises borrowing costs, and rising interest rates eat into earnings.
However, the relationship between interest rates and the performance of utility stocks is significantly more intricate than a simple negative correlation.
Regulated utility earnings and equity performance are generally driven by rate base expansion and rates of return approved by state regulatory commissions for the typical pure-play utility. RRA has been tracking the annual average approved ROES issued by PSCs since 1988. Authorized ROEs keep a careful eye on interest rate movements.
As expected, approved ROEs and interest rates have a strong positive association, but interest rates and utility stock indexes have a strong negative correlation for the reasons stated above (see attached data sheet). Utility stock indices are also substantially connected favorably with broader equity markets, as assessed by the S&P 500 Index, when looking at yearly average data from 1988 to 2016. Utilities tend to follow the general stock market, albeit at a slower pace, with lower highs and higher lows.
What investments do well in the face of inflation?
- In the past, tangible assets such as real estate and commodities were seen to be inflation hedges.
- Certain sector stocks, inflation-indexed bonds, and securitized debt are examples of specialty securities that can keep a portfolio’s buying power.
- Direct and indirect investments in inflation-sensitive investments are available in a variety of ways.
In a downturn, are utility stocks a decent investment?
Utility companies are an excellent defensive stock because of their recession-resistant character. Utilities rarely have a quarter with unexpected results, but they do tend to hold up well in rough markets.
Is now a good time to invest in utilities?
Residential, commercial, industrial, and government customers receive electricity, natural gas, and water and wastewater services from utilities.
Utility stocks are generally considered to be safe investments. Even during a recession, demand for utility services tends to stay stable. Meanwhile, the fees they charge for providing these services are either regulated (by a government agency) or contractually guaranteed (nonregulated). As a result, utilities generate consistent earnings, allowing them to pay dividends with above-average returns.
Utility companies are lower-risk investments because of their predictable profitability and income creation. As a reason, they’re frequently good choices for retirement income plans.
Utility stocks, on the other hand, do not all provide attractive investment returns. Additional distinguishing traits of the finest utilities offer them the ability to outperform. With that in mind, here are some of the best utility stocks to buy and what to look for when investing in utilities.
Are utility stocks too expensive?
Even if inflation falls, investors should be careful when it comes to utility valuations. Based on our median price/fair value estimate as of late December, we believe the industry is 4% overvalued. Utilities have a 20 percent higher average price/earnings multiple than the 10-year trailing average. After a warm start to the winter, fourth-quarter earnings could be disappointing. Overall, utilities stocks appear to be on track for a similar steady but lackluster performance in 2022 as they did in 2021.
Who is the hardest hit by inflation?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford increasing mortgage payments and hence defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.
How do you protect yourself from inflation?
If rising inflation persists, it will almost certainly lead to higher interest rates, therefore investors should think about how to effectively position their portfolios if this happens. Despite enormous budget deficits and cheap interest rates, the economy spent much of the 2010s without high sustained inflation.
If you expect inflation to continue, it may be a good time to borrow, as long as you can avoid being directly exposed to it. What is the explanation for this? You’re effectively repaying your loan with cheaper dollars in the future if you borrow at a fixed interest rate. It gets even better if you use certain types of debt to invest in assets like real estate that are anticipated to appreciate over time.
Here are some of the best inflation hedges you may use to reduce the impact of inflation.
TIPS
TIPS, or Treasury inflation-protected securities, are a good strategy to preserve your government bond investment if inflation is expected to accelerate. TIPS are U.S. government bonds that are indexed to inflation, which means that if inflation rises (or falls), so will the effective interest rate paid on them.
TIPS bonds are issued in maturities of 5, 10, and 30 years and pay interest every six months. They’re considered one of the safest investments in the world because they’re backed by the US federal government (just like other government debt).
Floating-rate bonds
Bonds typically have a fixed payment for the duration of the bond, making them vulnerable to inflation on the broad side. A floating rate bond, on the other hand, can help to reduce this effect by increasing the dividend in response to increases in interest rates induced by rising inflation.
ETFs or mutual funds, which often possess a diverse range of such bonds, are one way to purchase them. You’ll gain some diversity in addition to inflation protection, which means your portfolio may benefit from lower risk.
Is gold a good inflation hedge?
- Gold is sometimes touted as a hedge against inflation, as its value rises when the dollar’s purchase power diminishes.
- Government bonds, on the other hand, are more secure and have been demonstrated to pay greater rates as inflation rises, and Treasury TIPS include built-in inflation protection.
- For most investors, ETFs that invest in gold while also holding Treasuries may be the best option.
In a worldwide recession, where should I put my money?
During a recession, a solid investing approach is to look for companies that are retaining strong balance sheets or stable business models despite the economic downturn. Utilities, basic consumer products conglomerates, and defense stocks are examples of these types of businesses. Investors frequently increase exposure to these groups in their portfolios in anticipation of declining economic conditions.