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 in times of inflation?
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.
In a rising-rate economy, how do utilities fare?
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 industries benefit the most from inflation?
Because energy is an input cost in all economic activity, the energy sector is perhaps the most renowned inflation-resistant sector of the stock market, and for good reason. Inflation often reflects increased energy prices, which have knock-on impacts on other goods and services.
Are utilities an effective inflation hedge?
The ability for utilities to offer a mechanism to hedge inflation risk is one of the fundamental components of the regulatory system that is likely to appeal to investors. As a result, utilities may be expected to have a higher ability to access capital markets than other industries during periods of significant inflation volatility.
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.
Are industrials a good way to protect against inflation?
Given its rate of return, the stock market tends to outperform inflation, albeit growth may be limited during inflationary periods.
“When future earnings are discounted to today’s currency, inflation reduces their value,” Goldberg noted.
As a result, he said, equities that are overvalued in comparison to the rest of the market may be more vulnerable to price declines.
Because inflation is usually associated with a robust economy, Goldberg recommends looking into cyclical companies, which follow the economic cycles. This includes industries such as manufacturing, energy, and consumer discretionary.
When interest rates rise, why do utilities decrease?
The second way that interest rates affect utilities is that they raise their borrowing costs. Of course, an increase in interest rates impacts all firms in this way, but utility companies are more vulnerable because of their high debt levels. Major utility companies have significant capital expenditures and a high debt-to-market capitalization ratio. The cost of building power plants and maintaining the huge infrastructure required to transport gas, water, or electricity makes utilities a very expensive industry that necessitates significant debt financing.
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.
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.
What happens to real estate when prices rise?
According to Zillow, the value of a typical middle price tier single family dwelling in the United States has soared by over 90% in less than ten years (through Sep 30, 2021). Home prices are expected to grow by 13.6 percent in the coming year, according to the business.
During periods of inflation, real estate values rise for a variety of reasons.
Income generating asset
Investors want assets that generate yields above and beyond the rate of inflation, which is one reason why real estate values rise during inflationary periods.
The rent received from a renter is used to cover operational costs, property taxes, and the mortgage. The return on investment, which is stated as a capitalization (cap) rate, is any money left over at the conclusion of each period. The net operating income (NOI) of a property is divided by the purchase price to arrive at a cap rate.
According to Arbor Research, single family rentals (SFRs) now have an average cap rate of 5.8%, but some rental houses listed for sale on the Roofstock Marketplace have anticipated cap rates of 7% or higher.
Cap rates on multifamily properties are around 5%, the 10-year Treasury yield is around 1.5 percent, and high-yield savings accounts pay 0.60 percent or less in annual percentage yield.
Limited amount of real estate
The fact that there is a finite supply of property compared to fiat currency is another reason why real estate values tend to grow with inflation. Real estate values should rise as the money supply expands as a result of increased money creation.
Assume that a hypothetical economy has a total of $1 million USD in circulation and that there are 100 houses with no other commodities or services available. If all of the houses were similar, each one would be worth $10,000.
Consider what would happen if the local central bank printed an extra $1 million over night. The economy would now be valued $2 million dollars, and each residence would be worth $20,000. Money printing, as the IMF has already stated, is one of the elements that causes inflation, as well as rising real estate prices.
Housing construction costs increase
Inflation raises the cost of building a home by increasing wages and increasing the cost of materials, suppliers, and land. Home builders, in turn, pass on the expense of building a new home to home purchasers and real estate investors, contributing to the rise in real estate prices.
According to the National Association of Home Builders (NAHB), overall building material prices have risen by more than 19 percent in the last year and 13% year-to-date. Lumber, gypsum board for finishing walls and ceilings, and ready-mix concrete are examples of home construction materials.