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The Year of Living Safely

Last year, utility investors were focused squarely on the Fed–but not so much anymore.

With the recent crash in global equity markets, further slumps in commodities prices, and slowing global growth, investor concerns about how utilities might perform in a rising-rate environment have given way to bigger worries about the broader market and the global economy.

If those fears are borne out, the resulting flight to safety could make utilities the place to be in 2016. For instance, while the S&P 500 is down about 6.1% this week, the Dow Jones Utility Average eked out a gain of 0.04%.

Equally important, such anxieties could cause the Federal Reserve to make the promised gradual pace of monetary tightening even more gradual–or prompt the central bank to back off rate hikes altogether. That would be another boon for utilities.

Certainly the Fed will give serious consideration to the fact that the S&P 500 just had its worst-ever yearly start since 1928.

This week’s global market meltdown began in China. And if what’s past is prologue, the Middle Kingdom’s woes will weigh on the Fed’s policymaking.

After all, China’s slowing growth and market swoon last summer likely factored into the Fed’s decision to defer its first rate hike in nearly a decade until this past December.

And even before China’s latest debacle, some viewed the Fed’s plans to raise rates gradually as more akin to a public-relations initiative to inspire confidence in the U.S. economy than as a move predicated on a strong economic resurgence.

Any optimism on the part of U.S. policymakers may have to yield to the slowing global economy. This is the fifth straight year in which global growth is forecast to be below 3%, while emerging economies from Brazil to China are expected to continue shrinking.

For its part, the World Bank has cut its projection for U.S. growth to 2.7% this year, down from 2.8% in June, due to the surging U.S. dollar’s dampening effect on exports.

But the World Bank’s lower forecast sounds positively upbeat compared to Citibank, which recently advised clients to “underweight” the U.S.

All of these recent developments should be reason enough to seek safety from utilities while maintaining a diversified portfolio. But there is an even greater worry that economists don’t like to talk about: the specter of deflation.

The Wolf at the Door

One of our biggest concerns about recent global market turmoil is that it could lead to further declines in financial assets, a deepening in the commodities crash and a cycle of competitive devaluations in currencies such as the Chinese yuan. These are deflationary trends that could export overseas pain to the U.S. economy.

To be sure, we’ve been skeptical about the underlying health of the U.S. economy, in particular, and the global economy, in general, for some time now. Indeed, more than two years ago, as the Fed announced its intent to begin tightening, we wrote that the central bank’s “removal of stimulus could set the stage for another deflationary spiral.”

Up until now, improvements in U.S. growth, consumer spending and employment have been offsetting global weakness.

But it’s hard to ignore the fact that the Fed is pretty much the only major central bank that isn’t currently in easing mode. Clearly, its peers are already worried about disinflation, if not outright deflation.

What much of the mainstream media seem to ignore when talking about China and other countries that devalue their currencies is the deflationary impact that such actions have on U.S. businesses. These moves can force U.S. firms to lower their prices to stay competitive with overseas products, and that erodes earnings and stifles growth.

If continued global weakness leads to deflation in the U.S., then utilities will be the best investment in such an environment.

A deflationary spiral is a vicious cycle where price declines lead to lower production, which in turn leads to lower wages and demand, which leads to further price declines.

Amid deflation, capital preservation is king, and utilities offer relative security and stable income. That doesn’t mean share prices of utilities won’t dip during a downturn, but it does mean that they do a far better job of holding their value, while continuing to offer a steady payout.

Even when consumers cut back on discretionary spending, they’ll still pay for essential services to keep the lights on, the water running, and the media streaming.


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