Are Canadian Utilities an Opportunity in a Slowing Economy

November 10, 2023No Comments


Hello, and welcome once again to the Smart Money Dumb Money Show, and I am your host, as usual, Keith Richards. I’m President and Chief Portfolio Manager at ValueTrend Wealth Management, and today we’re going to be talking about the utility sector. Are Canadian Utilities an opportunity in a slowing economy?

 

Now, that sector has been absolutely hammered over the past couple of years, and a lot of people know why. It’s because of a couple of factors: First of all, investors were focusing on growth stocks. We all know about the ‘Magnificent Seven’ and how they’ve done in 2023, but it’s not just that, the tech sector has been kind of the only game in town for past couple of years. And of course, utilities being pretty much the exact opposite in business style as a growth-orientated technology company will take a backseat to that. The second thing is, that Canadian utilities are very sensitive to interest rates. So, if rates rise, they tend to experience less profitability.

 

Why? Because they borrow. They borrow because they have to constantly expand their services as populations in the communities they service expand on top of that. Yet, the revenue that comes from their clients is relatively fixed. So they’re really quite sensitive to interest rates because that’s one of their biggest expenses. That, and of course employees. So, if you’ve got rising rates, you have a fairly capped revenue that you can bring in, but those rising rates are going to take away some of the profitability on the loans you have as a utility company. So, that’s one of the reasons why utilities tend to do poorly in a rising rate environment.

 

Now, what we have right now in front of us is federal reserves across the world, I should say, are telling us that they’re becoming less hawkish. They’re looking at possibly pausing on rate hikes, and that’s eventually going to turn into probably declining rates as they tried to ward off a softening economy and/or recession that they have caused through these rate hikes. So, with that in mind, utilities may just catch a bid as the market starts believing that rate drops are coming. Let’s take a look at a few factors that I see in the utility sector that are kind of interesting and caught my eye the other day.

Utility sector - Are Canadian Utilities an opportunity in a slowing economy? Chart to support the concept from StockCharts.com

We’re going to take a look at a slide presentation I put together on PowerPoint, and this presentation was put together on November 2nd. You’re probably seeing this a week later, so just bear that in mind. The charts that you’ll see are probably about a week old, probably not a big concern today because I’m not really looking at a one-week trade. I’m looking at something that is quite possibly going to last a while. If we acknowledge that we are entering into early recession which I believe we are, and you know that I have been harping on this for a while now, I believe that we are going to be in a stagflation-type environment.

 

‘Stagflation’ means that you’ve got a stagnant type of economy and yet still a higher-than-normal inflation rate. Remember, I’ve harped on this many times that it is a highly improbable potential for seeing 2% CPI in the near future. So I believe that we’re going to see inflation come down to closer to three or three and a half percent, which by the way is the historic norm for CPI. But, more importantly, it’s what consumers are not used to. North American consumers – and even consumers in most of the developed world – are used to seeing lower rates. Well, that’s not likely going to happen. So, if we’ve got higher inflation and a slowing economy, that’s called ‘Stagflation’. Now, in a normal environment for a slowing economy, you can look to utilities, real estate, and financials as places to be. I’m just going to focus on utilities today because I think it’s a pretty interesting trade.

Canadian Utilities Sector chart by EquityClock.com

It’s so oversold. Just before I get into the charts, I want to show you the utility sector seasonality. This is courtesy of Equity Clock, and you can see basically between October to the end of the year, you can get some upside on a relative basis to the S&P 500 that is, on the utility sector. You can see that we draw this line, this is just a number 4%, and it shows an average return against the S&P 500 of an outperformance by about 4% because it goes from four to eight here. So that means that the utility sector under normal circumstances can outperform the S&P 500 by about 4% during the last three months of the year. So that’s something to keep in mind, but I think in particular because we are again entering into a recessionary environment or a slowing environment, utilities have another push or another wind behind their back.

Let’s take a look at some very recent action on a relative performance basis. I’m going to look at the utility sector since the beginning of October to the 1st of November. So, just the other day, as of the time of recording. You can see that utilities, which is this bar here, has outperformed virtually every other sector. What’s also interesting is that the three sectors that were mentioned in that economics chart that tells you the sectors that can outperform are starting to look better. Utilities in particular, but also financials and real estate. Now, I meant to post a chart of the sectors between September 1st and November 2nd, and you would’ve seen that utilities in particular were underwater for much of that month.

You can see there’s been this massive comparative return on utilities over the past month compared to where they were. So I think that’s of great interest. Let’s take a look at the Utilities Index in the US. Now, these are US utilities, but what you’ll find in a second is that the utilities in the States are pretty much looking the same as utilities In Canada. You can see that they were in a bit of an uptrend from 2020, kind of rounded over in 22, but really in 23, they just absolutely cracked. There’s that trend line that you can see here – I didn’t draw it in – but you can see has been cracked. You can see a declining series of peaks and troughs. It got extremely oversold with this possible reversal handle here. It’s a candlestick called a ‘hammer’, and that occurred in the early part of October.

 

And since then we’ve seen some outperformance like we just saw on the chart. So, it gets me wondering as to whether we might see a return into at least this kind of support resistance coagulation that we’ve seen up here, which could be a profitable trade. And we’ve got seasonality, we’ve got the economy working for us on this, plus an oversold situation that you can see with a bullish candlestick. This is the Canadian Utility Index. I’m using the BMO one. It’s an equal weight, so it’s kind of a little bit different than the US one we were just looking at, which is cap-weighted. This is equal weight. Bank of Montreal tends to do ETFs that are equal-weighted, and it really does show you there really was a drop if you look at the sector on the whole. And, I do think that you could at least see a return to this old neckline or higher in the sector over the coming months.

So, I just wanted to drop this thought into your head that for a 2- 3- 4-month trade, utilities might be of interest. We have a softening economy. We have slowing CPI, so that is good news for rates, and that means that utilities could start to become more profitable. And as you know, the market looks forward. It doesn’t just look at what’s happening now. The market may start to bid utilities higher and higher. In fact, as you saw on the relative performance chart, that pattern has already begun.

 

So, Canadian utilities might be a decent place to hold some of your equities if you want a high dividend and a potential move over the next few months, I think there’s a decent chance of that happening. Thanks for watching.

 

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