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Quarter-End Insights

Utilities: Still High Even After Bonds' Withdrawal

The utilities yield spread has turned much more bearish after bonds collapsed at the end of the year.

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  • On a global basis, utilities are undervalued for the first time since February, with a 0.97 market-cap-weighted price/fair value ratio as of Nov. 30. U.S. utilities have a 1.11 equal-weighted median P/FV, down from their peak 1.21 P/FV in early July. We see more value among the large European diversified utilities, but those come with higher uncertainty ratings and weaker economic moats.
  • We've long told investors that a wide spread between utilities' dividend yields and interest rates would dampen the market's reaction to rising rates. That played out when utilities stocks held firm even as the 10-year U.S. Treasury yield rose to 2.6% as of mid-December and the yield spread closed below 100 basis points for the first time in three years. With a tighter yield spread now, utilities stocks could become more sensitive to future rate moves.
  • We don't expect the Trump administration's political rhetoric opposing climate change regulations in the U.S. to affect utilities much. Cheap natural gas remains the overwhelming factor driving utilities' investment plans and earnings growth. Gas's low-carbon profile and improving renewable energy economics mean the U.S. might achieve carbon-reduction goals even without regulations.
  • We think the rampant pace of utilities sector mergers and acquisitions will slow as the list of acquirers shrinks. During the past two years, the five largest U.S. utilities and several large European utilities have executed or are near to closing transformative deals. We don't expect them to drink from the M&A well again any time soon, capping any M&A-related valuation premiums for small- and mid-cap utilities.

Travis Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.