Overview
Investors have been tap-dancing around utilities equities, unsure whether to own them for risk reduction or sell them in expectation of interest rates staying high for longer.
Shares of utilities companies have long been regarded as bond proxies for their stable cashflows and defensive qualities, and indeed, historically we’ve seen a strong negative correlation between the valuation of utility stocks and changes in interest rates, especially in developed markets.
But recent moves show something may be changing. This week’s Chart Room looks at the relationship between US utilities valuations and bond yields over the last three decades, and suggests that the long expansion of earnings multiples for the utilities sector may be running out of steam.
Since 1990, the price-to-earnings (P/E) ratio of the S&P 500 Utilities index has exhibited a negative correlation of -0.8 to corporate bond yields, meaning their valuation tends to drop by four fifths of the magnitude of bond yield increases. But most recently, a spate of rapid rate hikes has not been fully priced in.
As the chart shows, when Moody’s BAA Corporate Bond Yields (indicating the lowest level of investment grade credit) are in the 5 to 6 per cent range, utilities historically tended to trade at around 16 times forward earnings. But at the moment, while the yield gauge has risen to 5.6 per cent (up more than 2 percentage points from the start of 2022), the price-to-earnings multiple for utilities stocks has stayed comparatively high at around 17.5 times.
Most likely, as bank failures roiled equity markets in recent weeks, risk aversion has driven fund flows into defensive assets and buoyed utilities shares. However, we think the defensive quality of utilities is not enough to justify their current valuations. The earnings yields of US utilities, which are the inverse of their P/E ratios, have fallen below corporate bond yields. What’s more, the discount of their earnings yields to bond yields has widened to a level last seen in crisis years like 2001 and 2008. This is a strong indication of overvaluation (unless there is a recession around the corner with a magnitude worse than the Global Financial Crisis).
While the near-term macro outlook remains uncertain, we think that at current levels utilities have become less useful as bond proxies.
