The Canadian markets are up 5%, while the S&P 500 has soared 10% so far in 2023. It’s interesting to see how equities are holding strong even amid the rising recession fears and unending macroeconomic uncertainties. However, considering an impending economic downturn and ensuing interest rate cuts, one pocket looks quite appealing—utilities.
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Utility stocks outperform in market downturns
TSX utility stocks are well-placed to ride through a recession. And that’s because of their stable earnings profile. Utilities are often called “widow-and-orphan” stocks because of their stable dividends and less volatile stocks. However, they have notably outperformed in bear markets. For example, when the broader markets crashed by more than 30% in March 2020 amid the pandemic, TSX utilities at large corrected only by around 15%.
As markets take an ugly turn amid the economic downturn, investors take shelter in defensives like utilities. The less-volatile stocks protect capital, generating a decent amount of passive income at the same time.
Canada’s top utility stock Fortis (TSX:FTS) has seen several downturns in the past and has emerged even stronger. It derives almost its entire earnings from regulated operations, enabling stable dividends. CU stock currently yields 4%, higher than TSX stocks. It has increased shareholder dividends for the last 50 consecutive years. Such a long payment streak indicates stability and reliability.
Utility stocks outperform when interest rates decrease and vice versa. So, as rates turned higher, TSX utility stocks notably underperformed last year. But since rates might hold steady or move lower going forward, utility stocks will likely surge higher. Bonds will become less attractive in the falling rate environment, making utilities more appealing.
Another factor is improved profitability. Utilities are a capital-intensive business and they generally carry a large amount of debt. So, as interest rates fall, their debt servicing costs also fall, ultimately improving their bottom line.
High payout ratios and stable profitability
Canadian Utilities (TSX:CU) is another safe and reliable dividend-payer name investors can consider. It has increased its net income by 2% compounded annually in the last decade. That’s much lower compared to broader markets. However, utilities keep growing steadily even in recessions, thanks to the stable demand for their services.
Another differentiating factor about utilities is their high payout ratios. They give away a big portion of their earnings in the form of dividends. For example, it is common for utilities to have a payout ratio of around 70%–80%, whereas the broad market average is around 20%. Canadian Utilities distributed 85% of its earnings in dividends last year.
Conclusion
If a recession occurs in the near future, fast-growing sectors like tech and consumer discretionary will bear an oversized brunt of the downturn. That’s because their earnings have a high correlation with economic cycles. However, defensives like utilities will likely outperform. Stocks like CU and FTS offer a decent low-risk, moderate return proposition, which will stand tall in volatile markets.
