Friday, October 6, 2023
- Utilities have come under increased selling pressure as rising risk-free rates have made their dividend yields less appealing to investors.
- Higher rates also translate into higher funding and refinancing costs for the capital-intensive sector.
- Technically, the sector is extremely oversold and retesting a secular uptrend. While the degree of oversold conditions and near-record-high volume this week provide evidence of a potential capitulation, a trend change in interest rates will likely be required before the sector finds a bottom.
It is not too often the utilities sector steals the spotlight on a market stage enthralled by mega-cap tech stocks, artificial intelligence, monetary policy, and political turmoil, to name a few stars of the show. However, following a 7% price drop last week, the widely considered defensive and low beta sector became front-page news. So, to contradict P.T. Barnum, maybe there is such a thing as bad publicity?
Like most things in today’s market, rising interest rates have been behind the selling pressure. With short duration Treasury yields north of 5% and longer duration yields quickly approaching five-handle territory, the sector’s 3.9% dividend yield doesn’t exactly scream competitive, especially when investors have preferred more offensive areas of the market this year. Utilities are also capital-intensive businesses, meaning future financing for projects and debt refinancing needs have become much costlier. The rising cost of capital prompted NextEra Energy (ticker: NEE) to cut its annual distribution growth rate target down to 6% last week, representing half of management’s previous 12% growth rate target. John Ketchum, CEO of the renewable-focused utility, stated, “Tighter monetary policy and higher interest rates obviously affect the financing needed to grow distributions at 12%.”
Utilities have dropped over 20% this year and consistently underperformed the broader market. More recently, the sector pulled back from the declining 50-day moving average (dma) and took out key support off the October 2022 lows. The drop lower was underpinned by near-record-high volume (2nd and 3rd highest days on record) and created historically oversold conditions. The sector’s Relative Strength Index—a momentum oscillator used to measure the speed and magnitude of price action—dropped to only 17.7, marking its lowest reading since 2008. The next levels of downside support set up near $287.50 (key Fibonacci retracement level) and $280.50 (June 2020 lows).
The technical picture for the utilities sector looks even more interesting when zooming out to a longer-term perspective. As shown below, the sector has pulled back to support from a secular uptrend dating back to the 2002 lows. The bottom panel shows drawdowns of the sector over this timeframe, and despite currently being down 27% from the 2022 highs, history suggests things could get worse—especially if this uptrend is violated.
Looking for a Bottom?
If you are looking for a bottom in the utilities sector, you may want to first look for a bottom in Treasury prices (or a top in yields). The 10-year Treasury note—depicted by the bright blue line below—continues to fall, and utilities continue to follow. The correlation between the two assets has steadily increased since July, which is the period when Treasury prices really started to tumble, sending yields north of 4%. Unfortunately, downside momentum in the 10-year note since then has accelerated, widening the relative value gap between risk-free yields and utility sector yields. So, while the sector is extremely oversold and trading at over a one-standard deviation discount to the S&P 500, it may be cheap for a reason, at least until there is more evidence of a trend change in interest rates.
Utilities continue to struggle against a backdrop of rising rates. While record-high volumes and extreme oversold conditions provide some evidence of a potential capitulation point, a trend change in interest rates will likely be required before the sector finds a bottom. From a longer-term perspective, utilities have pulled back to support from a secular uptrend dating back to the 2002 lows. This inflection point could be the make-or-break moment for the sector, as a break below the uptrend would suggest a new secular downtrend is underway. If held, and upside pressure from interest rates abates, we suspect the sector could make a meaningful recovery from here.
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