In a Bloomberg article dated March 14, 2018, it cites a prevailing theme about utilities and interest rates.
“The popular ‘buy banks, sell utility stocks’ strategy, built in anticipation of higher interest rates, is unraveling.
“Utilities were the only gainers in the S&P 500 Index on Wednesday, with the industry that’s seen hurt most by rising Treasury yields heading for its longest rally since November. Financial shares, beneficiaries of higher borrowing costs, sank 1.4 percent for a third day of declines.”
While this is a small timeframe to measure the performance of any industry, it does shed some light on the popular interpretations about what a rising interest rate cycle will bring to the market. One of the most pervasive claims is the interest rate sensitive utilities will suffer with the advent of rising interest rates.
As pointed out in our September 4, 2014 article titled “Utility Stocks and Rising Interest Rates”, we said the following:
“Investors anticipating a general rise in interest rates should feel some comfort in knowing that most manager in the utility sector are ready for what is to come. Rising interest rates are not an automatic death sentence for utility stock prices or earnings. In fact, the early stages of rising interest rates may see utility stocks match or exceed the returns of non-interest rate sensitive stocks, on a total return basis. Only when the outlook is cloudy will it become difficult to offer projections that are in line with prior expectations.”
So far the market is in agreement with our long established thesis that utilities do well in the early stages of the secular rise in interest rates.
In the chart below, we compare the 3-month Treasury to the Dow Jones Utility Average from the beginning of the rise in rates (at 0.00% on October 22, 2015) as seen in the chart below.
The first point in the above chart is that contrary to the view that rising rates mean utilities will decline, the opposite has happened. In addition, the chart below highlights just how powerful the Dow Jones Utility Average has performed against the Dow Jones Industrial Average and the S&P 500 Index since the October 22, 2015.
By all accounts, the Dow Jones Utility Average is undervalued relative to the competing indexes compared above. We don’t think that much has changes in the impact of the utilities in the interest rate cycle from 1939 to 1966 and the current period since October 22, 2015.
Our recommendation, based on the above consideration, is to review the risks and rewards of the Vanguard Utilities ETF (VPU), currently priced at $110.61.