The Current State of the US Utilities Sector

US equities have generally been supercharged in the wake of the presidential election, but the utilities sector’s relative performance has dimmed instead. John Kohli and Blair Schmicker, portfolio managers for Franklin Utilities Fund, describe the post-election headwinds—including higher interest rates—that have challenged utilities recently, and the potential regulatory and technological changes that might spark the sector going forward.

US utilities have been lagging the broader US equity market over the last several months, but we believe utilities’ recent underperformance has little to do with any change in sector-specific fundamentals. Rather, the industry is facing two headwinds that are incidental results of the recent presidential election.

First, the sector has been hurt by the rise in long-term interest rates, which accelerated after the election. The rise in long-term interest rates lowers the multiple at which the utilities sector trades, since it is commonly regarded as a bond proxy, and bonds prices typically fall when interest rates rise.

Second, many observers believe the industry has some earnings risk as a result of potential corporate tax reform. The actual impact will depend primarily on the specifics of the reform, with policies regarding interest-expense deductions and 100% depreciation expensing being the critical elements for the industry.

And we believe these two factors will remain the primary driver of the sector’s relative performance going forward. In regard to interest rates, if US gross domestic product accelerates and an inflationary threat induces a hawkish response from the Federal Reserve, short- and long-term interest rates will have an upward bias that will likely further compress utility-capitalization multiples.

Likewise, if a more comprehensive tax plan, such as one being pushed by House Speaker Paul Ryan and the House Republicans, is implemented, on balance, it will likely weigh further on utility earnings, particularly compared with the broader indexes where the impact will likely be mostly favorable. For example, we believe most utilities would not benefit from lower corporate tax rates; regulators would likely require utilities to adjust their power rates lower to reflect the lower tax rate, meaning the customers, not the utilities, would benefit.

On the other hand, if these policy objectives are not enacted—or to the extent that they are “watered down” before passage—it could open up the potential for utilities to provide better relative performance. How large the impact, in either direction, will depend on specifics.

Regulatory Roulette

Moving to regulation, the election’s impact on federal environmental rules remains unclear, and energy does not appear to be a top initial priority for the administration. Last year, the Supreme Court delayed the implementation of former President Obama’s Clean Power Plan (CPP), which would have substantially cut carbon dioxide emissions. Under President Donald Trump’s administration, we would expect the CPP’s implementation to be delayed, presuming it survives court challenges. However, most state regulators have so far said they expect to continue pursuing a path toward CPP adherence, viewing the rule or something similar as an eventual inevitability.

Developments in Digitization

While the sector’s executives can’t control how interest rates and political decisions affect their companies, they have found ways to improve efficiency and curb expenses, including expanding their digital footprint.