Move over Magnificent Seven, utilities have arrived.
That was one takeaway this week after tech superstars on Wednesday suffered their worst selloff in about two years. On the same day, the Bank of Canada cut its key interest rate, which lifted utilities and highlighted the close link between monetary policy and these dividend powerhouses.
Lower rates make dividends look more attractive relative to safe bonds, and utilities are known for their steadily rising dividends and relatively large yields. More rate cuts will most certainly help underpin the rally, which is why these stocks are known as bond proxies: As rates decline, prices tend to rise.
If more rate cuts are coming and tech stocks lose some of their lustre, is this the sector to own?
The S&P/TSX utilities index, composed of 15 stocks including Hydro One Ltd. H-T, Fortis Inc. FTS-T and Emera Inc. EMA-T, gained 0.6 per cent on Wednesday.
That might not look like much, but it was by far the best performance among the 11 sectors in the benchmark on a particularly rough day for North American stocks.
Consider that the Big Six banks – which stand to benefit from lower interest rates in the form of fewer loan defaults – declined by an average of 0.5 per cent.
Worse, the tech-heavy Nasdaq Composite Index and the S&P 500 index of large U.S. companies suffered their biggest selloffs since 2022.
The Roundhill Magnificent Seven ETF, an exchange-traded fund that holds the likes of Tesla Inc. TSLA-Q, Nvidia Corp. NVDA-Q and Microsoft Corp. MSFT-Q, slumped 6.1 per cent, marking the fund’s fifth decline in six trading days.
To be sure, Nvidia, which makes chips that power artificial intelligence, is still up 128 per cent so far this year amid gargantuan profits that have soared with the potential for AI.
But this week’s tech turbulence bolsters the case, made by a number of market strategists in recent weeks, that a market rotation could be in the works as investors search for other opportunities.
John Christofilos, chief trading officer at AGF Investments Inc., said in an e-mail that he expects the gains of large technology stocks will slow as other stocks gain favour among investors.
He believes the sectors that stand to gain will be those that “will benefit from a lower rate environment that I believe we will be entering globally – and that includes utilities, as well as financials and energy.”
Signs of easing U.S. inflation, which have lifted U.S. utilities as well, support the case. The U.S. Composite PMI Output Index, released this week, showed that prices charged in July are consistent with 2 per cent inflation.
Though economists had been expecting the Bank of Canada to cut its key rate, the outperformance by utilities suggested some unanticipated delight among investors. This delight may have flowed from the PMI reading, but it also follows the central bank’s suggestion that more cuts are coming as inflationary pressure subsides.
Besides the well-known inverse relationship between interest rates and their stock price, utilities are economically bulletproof and removed from geopolitical tensions, making them ideal havens during periods of uncertainty. To boot, lower rates reduce the borrowing costs of what are usually highly leveraged businesses.
Utilities should also benefit from Canada’s strong immigration numbers, which translates to more customers, and the move toward electrification, where electric vehicles and heat pumps tap into the grid. AI, which consumes an enormous amount of electricity through data centres, is another source of growth – and one that has propelled U.S. utilities this year.
Yet, despite Wednesday’s market-beating gain, Canadian utilities remain in the shadows. The sector has gained just 2.2 per cent this year, not including dividends, which is the second-worst performance next to telecom stocks.
Over the past 12 months, as of Thursday, the sector has declined 5.4 per cent and underperformed the broad S&P/TSX Composite Index by nearly 16 percentage points.
There are risks. Although Bank of Canada Governor Tiff Macklem said this week that the expected direction for interest rates is lower, he cautioned that “we’re not on a predetermined path.”
Stickier inflation and rebounding economic activity could affect the timing of additional cuts.
What’s more, the Federal Reserve has not yet begun to cut its key interest rate. If it remains on the sidelines, Canada’s central bank may be reluctant to cut rates further because of concerns about sinking the value of the Canadian dollar.
Still, this week’s action highlights the upside opportunity here. If more rate cuts are coming, utilities are nicely positioned to reward investors.