Such companies have done better than growth stocks, which offers insight into what people think about interest rates
By Jon Sindreu
To catch a glimpse of the deep-rooted mechanisms of central bank policy and its linkages to economic growth, there is nothing like looking at utility stocks.
Utilities’ rally since the start of 2020 is on par with the red-hot Nasdaq-100 Index. As a result, the valuation of the S&P 500 Utilities index is near an all-time high, with shares trading at almost 24 times the earnings of those companies, compared with 21 times for the broader S&P 500.
On first glance, boring water or electricity providers like Essential Utilities, American Water Works and Entergyhave little in common with the excitement of the headline-grabbing technology giants. Yet all these companies now have dearer valuations than Apple, Alphabet, Microsoft and Facebook.
Since 2019, the valuation premium that investors place on utilities has been around its highest level ever. Part of last year’s bump was explained by a jittery market, which pushed up the shares of so-called defensive companies—those with stable earnings that aren’t as exposed to economic busts. But that trend unraveled after October.
Investors are now giddy about go-go growth stocks, despite momentary concerns about the Chinese coronavirus. And yet, utility stocks have found renewed vigor.
It likely has to do with central banks and how they address tectonic shifts in common wisdom.
Surveys by Bank of America Merrill Lynch show that fund managers have piled into assets that do well when inflation collapses, like bonds, tech stocks and emerging markets, while selling “value” sectors like banks and energy. Yet market expectations for prices remain very stable, showing no fears of a deflationary spiral like they did back in 2016. Instead, it is expectations of inflation-adjusted or “real” interest rates that have collapsed.
Before the 2008 financial crisis, this was a bad omen because real rates were seen as reflecting the economy’s growth potential. And yet, real rates have appeared to follow officials’ every attempt to lower them, rather than being governed by deep-seated economic forces.
At the same time, inflation has remained subdued across the Western world, suggesting that trends in consumer prices often have little to do with monetary policy, or even growth and employment.
In the new era of central banking, utilities are long-term winners. / Photo: seth herald/Agence France-Presse/Getty Images .
In short: Central banks’ power over markets has revealed itself as greater than previously believed, but their power over the economy as much less.
This has strong ramifications. For one, rates could stay low regardless of what the economy is doing.
Last year, the Federal Reserve slashed rates following an equity selloff even as the job market showed no signs of trouble. This supports the idea that, at the very least, getting ahead of inflation is a much less pressing concern for central banks than it once was.
If true, it makes sense to put a premium on both tech stocks, which are valued on expectations of higher future potential, and utility stocks, which are stable dividend-payers and thus basically track bond yields.
There are other factors such as the trend toward decarbonization, which has given a boost to firms like NextEra Energy,the world’s largest generator of solar and wind energy. That doesn’t mean valuations aren’t overstretched, however, just as Treasury yields seem a bit too low for current Fed policy.
Neither seems to offer a buying opportunity right now—but in the new era of central banking, utilities are long-term winners.
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