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Utilities rose 3% in June on the back of continued declines in L-T rates.  But the market left utilities in the dust rising 7% for the month.  The S&P 500 is now up 17.3% for the first half of 2019, the best performance since 1997.  Utilities have held their own up 12.8%, but still trail by 450bps.  At least so far, it appears that lower interest rates are helping the broader market more than utilities.  Lower rates are a double-edged sword for utilities (see our recent report), as they can lead to lower allowed ROEs in rate cases.  Several of the more near-term exposed companies – PNW, CNP, AGR, ED and AEE – were among the worst performers last month. 

Utilities have rallied on the large drop in interest rates in recent weeks.  For the year, 10-year Treasury yields have dropped to 2.01% from 2.69%.  While underperforming the market, utility stocks are up 12% YTD and valuations are at or near all-time highs.  This has been great news for investors, but lower interest rates are a double-edged sword for utilities.  They increase the risk of lower allowed ROEs in rate cases which have otherwise held pretty stable over the past year.  In this report, we identify those most and least at risk to ROE cuts and highlight pending cases with ROE sensitivity. 

The revival of the US/China trade war stopped the 2019 bull market in its tracks with the S&P 500 falling 6.6% and bond yields declining 36bps in May.  Utilities were a place to hide and only fell 1.3% beating the market by 530bps.  For the year, utilities are still slightly trailing the S&P 500 (9.4% vs 9.8%) though it feels like they are way ahead.   Utilities are back to a 21% P/E premium to the market vs a historic average of 3%.  They have hit this level a few times before – including this past December – and its proven to be great selling opportunities since this premium never lasted. So while we worry about the economy and trade wars and bonds going toward zero yields, we still think buying utilities here is buying near a peak and stay Underweight.  With rates this low, we are more wary of utility rate cases and ROEs – last month we saw NY PSC staff recommend an 8.3% ROE for ED.

Our Q1 investor poll shows investors remain underweight utilities even after the sector has already underperformed by 700bps YTD.  The poll has eerily similar results compared to our year ahead poll.  Only 22% expect utilities to outperform for the rest of 2019 (down from 29%) and 54% expect them to underperform (up from 51%).  There is roughly the same preference of midstream vs utilities (60%/40% vs 62%/38%).  Power remains the preferred sector within the space (52% overweight vs 53% last poll) followed by Regulateds (43% overweight vs 52%) and then Yieldcos at the bottom (25% overweight vs 33%).  Most investors (59%) expect interest rates to stay in the 2.5%-3.0% area though a lot less see rates rising back over 3% (only 5% vs 22% at last poll).