[MUSIC PLAYING] * Rate sensitive sectors like utilities have had a tough ride amid the recent central bank hiking cycle. But with interest rate cuts expected by many this year, could things be turning around for the sector? Joining us now to discuss is Mary Ferguson, analyst with Argus Research. Mary, great to have you on the program. * Thanks for having me. * Well, let's talk about the utility space. We've got a lot to get into here. First, let's talk about the current economy. Utility stocks, are they seen as a defensive investment considering what we're going through? * Yes. They have historically been seen as a defensive stock, meaning they will have more stable earnings and consistent returns during a weaker economy and market downturn. Typically, defensive stocks relate to well known companies that provide goods, services, what consumers need regardless of what consumer spending is. And so utilities fit the bill. * Another reason utilities often trade as a defensive stock is that they are regulated. So most public utilities are highly regulated in an effort to remain stable and typically have year-over-year growth around 3% to 5%. Regulators, they don't just set what our electric and natural gas rates are. They actually work with the utilities to set rates that will help the utility meet their revenue requirements for the year. * Regulators also have oversight as to items on the balance sheet. They overlook debt cap ratios, and they set return on equity on capital investments. So utilities are known to have a little lower risk, more modest equity return. But they're also low beta. And they also usually provide a stable dividend income, often importantly qualified dividends, which are taxed at a lower long-term capital gain rate than other income-- rather than normal income. * This can appeal to certain investors who are willing to accept the total return of equity growth and the dividend contribution. It's interesting. Right now, the average dividend yield in the S&P 500 is about 1.6%. The average dividend yield for utilities is 4%. So if we're looking at 2% to 3% earnings growth, stable growth, a defensive stock, we're looking at 4% income growth. * So not all utilities pay equally or raise their dividends equally. But they're typically very stable. And we very rarely see dividends suspended. So I just want to point out, for example, Duke Energy in the utility sector has been paying dividends for 99 years without missing a year. * Con Ed, our local New York utility, has had 50 consecutive years with annual rate hikes. So typical rate hikes are 2% to 3%. But in our sector and in the stock side cover, we'll see-- this year, we expect some rate hikes close to 7% or 8%. For instance, from Nextera and from Wisconsin Energy, we expect much higher than peer dividend increases. * So we got a nice rationale there as to why investors look to the utility space as part of a portfolio. What does it mean, though, when we hear that utilities are sensitive to interest rates? Because obviously, interest rates are pretty much all we've been talking about for the past year and a half or so. * That is a well followed, pretty well proven historical trend that utility stocks decline in price when interest rates rise, or in periods of prolonged high interest rates. The reasoning behind this is that when rates interest rates go up, large institutional investors will leave the equity market and sell their shares and move over to the fixed income market. So while interest rates rise, share prices can remain sluggish. But conversely, dividend yields also rise. * So when rates are high, share prices often decline. And for interested investors, you can follow the timing. It could provide an opportunity to enter the sector. * The benchmark, I just want to point out that we typically use in the sector to gauge rates is not really just mortgage rates, but the 10 year treasury yield. So that's been hovering around 4.3%. So we're almost equaling that with our dividend yield in the sector. * And we do have expectations of rate cuts, right? * Better performance. I'm sorry? * I was just saying, and we do have expectations this year of rate cuts from the Fed at some point. It's still early in the year. I feel like the market's a little impatient. But there's still expectations that we'll get these cuts. So what would you expect from utilities this year in the way of their earnings? * OK. Well, I just want to say what we're expecting-- I think almost all economists on the street are projecting that interest rates are going to ease some point in 2024. Our Argus economists are projecting that they're going to probably have three quarter point down ticks in the second half of 2024 with some continued easing in 2025. So with rates going down, I just want to point out some historical facts to prove up this theory that it could be a good time to get into the utility sector. * So since 2007, we've had roughly about five periods of interest rates, a continued declining treasury yield and rates that are going down. In 2011 when rates were going down, utilities were the best performing sector. In 2014 when treasury yields were declining, utilities were the second best sector. And in 2018, they were also the second best performing sector as rates were declining. Conversely in 2020 to 2023, rates have been up and utilities have been a bottom five performing sector. * So that's a nice historical context for it. Obviously, if we do see the rate cuts coming this year, as you said economists are expecting, we can start to see some share price movement. What about the actual earnings? I mean, utilities are also sort of capital-intensive industries. And well, they have to borrow, right? Just like anybody else. * They do have to borrow. Interest rate pressure has been a headwind to earnings. There are some generalizations we make about the sector. In a more sluggish economy, stocks tend to follow and trade on news of interest rates. * As the economy improves, we see the stronger and larger companies starting to trade on news of earnings growth and dividend hikes. Very generally, customer growth adds to the top line. New asset development adds to the top line, whereas regulatory increases energy prices, cost savings, that adds to earnings. So what are we going to expect for earnings in 2024? I think we need to look at two things that have happened. * So in 2022, we saw soaring energy prices. Wholesale electricity costs were high across the country. Natural gas prices were high. We were seeing-- my benchmark is the Henry hub spot price. We were seeing prices above $5 for million BTU over much of the year. We were seeing prices as high as eight during the summer. Going forward in 2024 and 25, we're expecting to see prices closer to $3. * We're not expecting to see prices-- natural gas prices go up and approach $5 until 2025. So we're going to see cost savings. That is going to drive earnings. And the other thing is weather. * Most of the US, most utilities had substantially milder temperatures. The mildest temperatures on decade. And so we saw earnings drop, not just what would be usual. In one quarter, we'd see 3%, 4%. We were seeing 8%, 9%, 10%, even as much as 15% or 20%. * So the good news is most weather forecasts are saying we're returning to normal weather in 2024. So I think we can expect our utilities to have substantial earnings growth in the first quarters and the third quarters. And that's from the favorable comparisons when they suffered so much last year.
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