The Argument for an Overweight Position in Regulated Utilities

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Eric Selmon 

Office: +1.646.843.7200

Email: eselmon@ssrllc.com

Hugh Wynne

Office: +1.203.901.1624

Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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October 5, 2016

The Argument for an Overweight Position in Regulated Utilities

  • Absent a change in market and sector PE multiples, regulated utility stocks today seem to combine materially higher expected returns (7.8% to 8.6% p.a., over a 3 to 5-year term) than the S&P 500 (6.1% to 7.3% p.a.) with a beta that is well below market (0.5 over the last three years and 0.4 over the last 12 months). (For the calculation of these estimated returns, please see Exhibits 2, 3, 4 and 5.)
  • That expected returns on utility stocks should exceed those for the broader market by 130-170 b.p. likely reflects investors’ fears of a sustained increase in long term interest rates. Historically, the best predictor of the sector average PE multiple for the regulated utilities has been the yield on corporate bonds; since 1978, a regression analysis between the yield of Moody’s corporate Baa index and the market cap weighted PE multiple of the regulated utilities results in an r-squared of almost 90%.
  • This is reflected in the negative correlation between changes in bond yields and the relative performance of utility stocks. A regression analysis of regulated utilities’ relative returns (measured against the S&P 500) vs. changes in 10-year Treasury yields shows that over 2003-2016 a 100 b.p. increase/(decrease) in yields is associated with 875 b.p. of utility under/(out)performance (Exhibit 9).
  • This relationship is not perfectly linear, however. As can be seen in Exhibit 10, the relative performance of regulated utility stocks has been far more sensitive to movements of 100 basis points or more in the 10-year Treasury bond yield that it has to movements of 100 basis points or less. That the relative performance of regulated utilities should be far more sensitive to large than small movements in rates perhaps reflects the qualitatively different drivers of extremes moves in bond yields. In recent years, the triggers of the largest moves in Treasury yields have tended to be changes in systemic risk that have caused investors fundamentally to reassess their risk appetite.
  • More sensitive than other equities to increases in bond yields and less sensitive to increases in financial, economic and geopolitical risk, utilities have become the yo-yos of the financial market, grasped by investors in times of economic pessimism and financial and geopolitical instability and then flung away as conditions normalize. This is reflected in recent years in atypical levels of volatility in regulated utility stocks. In the three of the last four years, the volatility of the regulated utilities, as measured by the standard deviation of their monthly returns, has significantly exceeded that of the S&P 500 (see Exhibit 12).
  • Critically, however, the causes of utilities’ volatility – swings in investors’ perception of financial, economic and geopolitical risk, and consequently in their appetite for lower risk assets – drive utility stocks in the opposite direction of the broader market. As a result, regulated utilities’ beta, which measures the covariance of the sector’s total return against that of the S&P 500, has been declining and is now at historically low levels, averaging only 0.4 over the last 12 months (see Exhibit 13).
  • Given these considerations, what weight should utilities have in equity portfolios today? We believe a framework for this investment decision is provided by our analysis of the sensitivity of utilities’ relative returns to movements in 10-year Treasury bond yields, as set out in Exhibit 10.
    • Given the marked underperformance of regulated utilities during 12-month periods when 10-year Treasury yields have increased by more than 100 basis points, the sector is clearly unattractive to investors expecting a material, sustained increase in long term interest rates.
    • Investors who expect only a modest increase in long term interest rates, however, may wish to have a market or even an overweight position in regulated utility stocks. Since 2009, increases of less than 100 b.p. in 10-year Treasury yields in any 12-month period have been reflected, on average, in 140 b.p. of underperformance by regulated utilities. Against this, we expect annual returns on regulated utility stocks to be 130-170 b.p. above those of the S&P 500 for the next three to five years. The first year of these excess returns might be sacrificed to the increase in rates, but investors would likely continue to enjoy higher relative returns in subsequent years, as well as benefit from the remarkably low beta of the sector.
    • Finally, those who believe bond yields will remain lower for longer due to persistently low inflation and GDP growth would be well advised to overweight the regulated utility sector to capitalize on its potential excess returns and very low beta.
  • Finally, we note that regulated utility stocks — with higher expected returns than the S&P 500, and a historically low correlation with the broader market – seem to offer a better risk adjusted return than they have in the past. Under these circumstances, adding utilities to a diversified portfolio of investments should improve the risk adjusted returns of the portfolio.  From this theoretical perspective, regardless of their views on interest rates, portfolio managers should maintain at least a marketweight position in utilities and possibly even overweight the sector, depending on the risks and returns of the other investments in their portfolio.

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology

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Source: FERC Form 1, company reports, SNL, SSR analysis

Details

In this note, we estimate the expected returns on regulated electric utility stocks, absent a change in the sector PE multiple, based upon the market capitalization weighted average dividend yield of the sector plus assumed dividend growth. We have estimated the future growth of utility earnings and dividends in two different ways: first, based upon consensus estimates of earnings over 2016-2018 and, second, based upon forecast growth in the aggregate electric rate base of the regulated utilities over 2015-2020 (see the appendix to this note for the assumptions underpinning our rate base forecast).

Among regulated utilities, growth in rate base is one of the fundamental drivers of long term earnings growth. Rate base represents the capital invested by a rate-regulated utility monopoly in the supply of a public service (e.g., electricity or gas) and in the United States is roughly equivalent to the net depreciated historical value of the utility’s plant, property and equipment, net of the utility’s deferred tax liability. [1] On the portion of rate base funded with equity (a proportion set by regulators at a level deemed adequate to sustain an investment grade rating on the utility’s long term debt, and referred to as the “equity ratio”), utilities are allowed to earn a fair return (the utility’s “allowed ROE”) as determined by regulators in periodic rate cases. Given this regulatory framework, it is common for investors to estimate future utility earnings as the product of rate base, the utility’s equity ratio and its allowed ROE.

Exhibit 2: Historical and Forecast Growth of Aggregate Electric Utility Rate Base, 2010-2015 v. 2016-2020

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Source: FERC Form 1, SNL, company reports and SSR analysis

Our analysis of the annual financial filings made by U.S. investor owned utilities with the Federal Energy Regulatory Commission (FERC Form 1) suggests that the aggregate electric rate base of these companies has expanded at a compound annual rate of 6.1% over the period from 2010 through 2015. We expect rate base to continue to expand at a similar rate in the years ahead: the capital expenditure plans of the publicly traded U.S. electric utilities are consistent with the continued expansion of their aggregate rate base over the next five years (2015-2020) at a rate of 6.2% p.a. (See Exhibit 2 and the appendix to this note. For a more detailed exposition of our analysis, readers are referred to our research note of April 13, Is This the Golden Age of Electric Utilities? A Primer on Historical and Forecast Rate Base Growth.)As noted above, it is common for investors to estimate the long run trajectory of utility earnings based upon the product of rate base, the equity ratio and allowed ROE. Absent a change in the average equity ratio or allowed return on equity of the industry, the rate of growth in industry earnings should track that of rate base. To estimate future growth in earnings per share, however, allowance must also be made for expected increases in utilities’ share count over time. Given the high dividend payout ratios typical among U.S. regulated electric utilities (the industry average is ~60%) it is not uncommon for these companies to fund a significant component of the growth in the equity component of rate base through new share issuance. Over 2010-2015, when the historical pace of growth in rate base (6.1% p.a.) was virtually identical to our forecast for 2015-2020 (6.2%), we calculate that the share count of the industry increased at ~1.2% p.a. [2]Assuming that over the long run the growth in aggregate rate base will drive a commensurate increase in industry earnings, and allowing for the historical pace of equity dilution, the average growth in earnings per share of the U.S. regulated electrics over the next five years can be estimated at 5.0% p.a. (see Exhibit 3). Given that the market-capitalization weighted average dividend yield of the U.S. regulated electric utilities is ~3.6%, assuming dividend growth is inline with earnings growth and assuming no change in the average sector PE multiple, we can estimate the total shareholder return for the sector over the next five years at ~8.6%.

Exhibit 3: Estimate of the Total Shareholder Return of the Publicly Traded U.S. Regulated Utilities, 2015-2020, Based Upon Growth in Rate Base, Equity Dilution and Dividend Yield


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Source: FERC Form 1, SNL, company reports and SSR analysis

An alternative estimate of total shareholder returns in the sector can be constructed based upon its current dividend yield and consensus estimates of EPS growth. Consensus EPS estimates for 2016-2018 are consistent with compound annual growth in sector earnings of 4.2% over 2015-2018. Adding the sector’s average dividend yield of 3.6% and again assuming no change in the average sector PE, total shareholder returns over this period can be estimated at 7.8% p.a. (see Exhibit 4).

Exhibit 4: Estimate of the Total Shareholder Return of the Publicly Traded U.S. Regulated Utilities, 2015-2018, Based Upon Consensus Earnings Estimates



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Source: FERC Form 1, SNL, company reports and SSR analysis

In summary, absent a change in the sector PE multiple, the expected return to shareholders in U.S. regulated electric utilities seems to fall in a range of 7.8% to 8.6%. Surprisingly, given the very low beta of the U.S. regulated electric utilities as a group (~0.4 over the last 12 months[3]), expected returns on the S&P 500 seem to be materially lower.

One way to estimate expected stock market returns, absent any change in the market PE, is by reference to the market’s current earnings yield. Based on forward 12 month earnings estimates, the earnings yield of the S&P 500 is currently 5.4%. As these earnings will be paid out as dividends, used to repurchase stock, or reinvested for growth, earnings yield can be thought of as a proxy for expected shareholder returns, assuming no change in the general price level. As corporate earnings can be expected to rise with inflation, however, an estimate of total shareholder return in nominal terms must also reflect the impact of future inflation. Based on the average estimate of the economists surveyed periodically by The Wall Street Journal, we estimate future inflation at 1.9% over 2015-2018. Adding the expected rate of inflation to the market’s forward earnings yield, we estimate the total shareholder return on the S&P 500, in the absence of a change in the market PE multiple, at some 7.3% (see Exhibit 5).

Exhibit 5: Estimate of the Total Shareholder Return of the S&P 500 Over 2015-2018, Based Upon Current Forward PE and the Average Estimate of Future Inflation


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Source: Dow Jones, SSR analysis

An alternative approach to estimating the future total return of the U.S. equity market is to assume that (i) the dividends of the companies that comprise the S&P 500 will track the growth in their future earnings, and (ii) that the rate of growth in these earnings will be bounded by the growth in U.S. nominal GDP. We note that the aggregate after-tax earnings of U.S. companies now account for 6.3% of U.S. GDP, more than one standard deviation above the post-World War II mean of 5.2% (see Exhibit 6). To assume that the growth in corporate earnings will exceed the growth of nominal GDP going forward implies a further increase in the profit share of GDP. Equally if not more likely, in our view, is the possibility that the profit share of GDP reverts to mean, continuing its recent downward trend from its 2012 peak of 7.0%. Further erosion in the profit share of GDP would seem consistent with the tightening of the labor market: labor costs, as measured by the Bureau of Labor Statistics’ constant dollar Employment Cost Index, have increased sharply over the last two years as the unemployment rate has dropped to the region of 5.0%[4] (see Exhibit 7).

Exhibit 6: Aggregate After-Tax Earnings of U.S. Companies as a Share of Gross Domestic Income, 1946-2016

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Source: Bureau of Economic Research

Exhibit 7: Private Sector Employment Cost Index (Constant Dollars) Plotted Against the Rate of Unemployment, 2006-2016

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Source: Bureau of Labor Statistics

Based on the average estimate of the economists surveyed periodically by The Wall Street Journal, we estimate future growth in nominal GDP at 4.0% over 2015-2018, slightly higher than the 3.6% annual rate registered since the end of the Great Recession in Q3 2009. Adding the dividend yield of the S&P 500 (2.1%), we thus estimate the total shareholder return on the S&P 500, in the absence of a change in the market PE multiple, at some 6.1% (see Exhibit 8).

Exhibit 8: Estimate of the Total Shareholder Return of the S&P 500 Over 2015-2018, Based Upon Current Dividend Yield and the Average Estimate of Nominal GDP Growth


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Source: Dow Jones

In summary, absent a change in market and sector PE multiples, regulated utility stocks today seem to

offer materially higher expected returns (7.8% to 8.6% p.a., over a 3 to 5-year term) than the S&P 500 (6.1% to 7.3% p.a.) – despite a sector beta of 0.5 over the last three years and 0.4 over the last 12 months.

That expected returns on utility stocks should exceed those for the broader market by 130-170 basis points likely reflects investors’ fears of a sustained increase in long term interest rates, which would have a greater impact on the valuation of regulated utilities than on the equity market as a whole. Historically, the best predictor of the sector average PE multiple for the regulated utilities has been the yield of long term corporate bonds; since 1978, a regression analysis between the yield of Moody’s corporate Baa index and the market capitalization weighted average PE multiple of the regulated utilities results in an r-squared of almost 90%.

The extreme sensitivity of utility valuations to changes in long term interest rates reflects the high degree of predictability of utility revenue, earnings and dividends and, as a result, the greater relative importance of the discount rate applied to these future earnings and dividends in assessing the value of the stocks. The predictability of utility earnings, in turn, reflects the fact that these companies are monopoly suppliers of an essential, networked service. Even in the absence of competition, cycles in economic growth might still be a threat, but in fact these have relatively little impact on utility revenues and earnings. First, the income elasticity of demand for electricity is very low in the residential and commercial segments, which together account for approximately two thirds of total demand, so that volume sales of electricity are relatively stable through the economic cycle. Second, electricity rates are subject to cost-of-service regulation, so that utilities cannot raise prices during economic expansions nor lower them in recessions, further stabilizing revenues. Third, a key component of utilities’ total cost of supplying electricity, their cost of fuel and purchased power, is in most states a pass-through to customers, stabilizing gross margins in the face of commodity price movements. Rather than responding to competitive pressures, economic cycles or changes in commodity prices, regulated utility earnings are fundamentally a function of utilities’ regulated rate base, equity ratio, and allowed return on equity. These three factors change at a glacial pace relative to the level of interest rates.

An increase in long term interest rates will raise the discount rate used to value any stock, but for economically sensitive stocks this impact is mitigated by the factors that trigger the interest rate increase. Bond yields tend to reflect market expectations for future economic growth and inflation and, reflecting these, the expected stringency of monetary policy. Thus an increase in interest rates brought about by an expected acceleration of GDP growth or inflation would – for a company whose volume sales and prices are sensitive to these variables — likely be accompanied by upward revisions to forecast revenues and earnings, mitigating the impact on its market valuation.


The greater sensitivity of utility valuations to movements in bond yields is reflected in a negative correlation between changes in bond yields and the relative performance of regulated utility stocks.

This is illustrated in Exhibits 9 and 10, which plot the relative returns on the S&P Utility Index (measured against the returns of the S&P 500) against movements in the 10-year U.S. Treasury bond yield over the period 2003-Q3 2016. We have chosen this time period for our analysis because it allows us to assess the relative performance of utility stocks over the last two economic expansions, as well as the intervening recession, while avoiding the valuation distortions in both the S&P 500 and the S&P Utility Index that accompanied the dotcom bubble.

More specifically, Exhibit 9 presents the results of a regression analysis of (i) the relative return of S&P Utility Index, including dividends, measured against the S&P 500, versus (ii) changes in the yield of the 10-year U.S. Treasury bond. (Both the relative return of the S&P Utility Index and the change in the yield of the 10-year Treasury were measured over the subsequent12-month period for each day from the beginning of 2003 through the third quarter of 2016.) The regression equation has a slope of -8.75, suggesting that on average a 100 basis point increase/(decrease) in 10-year Treasury yields over a 12-month period is associated with 875 basis points of (under)/outperformance by the S&P Utility Index. The r-squared of the regression equation, at 0.255, suggests that this relationship explains approximately a quarter of the relative performance of the S&P Utility Index.

While a linear regression analysis such as that in Exhibit 9 will always derive a linear relationship between two variables, in fact, utilities’ relative under-performance or out-performance vis-a-vis the S&P 500 is not consistently proportional to the magnitude of the increase or decrease in Treasury bond yields. As can be seen in Exhibit 10, the relative performance of regulated utility stocks has been far more sensitive to movements of 100 basis points or more in the 10-year Treasury bond yield that it has to movements of 100 basis points or less. Thus increases of over 100 basis points in Treasury bond yields over a 12-month period have been associated with average underperformance by the regulated utilities of 13.6 percentage points, but increases of less than 100 basis points have associated with utility underperformance of only. 1.4 percentage points. Similarly, decreases of over 100 basis points in Treasury bond yields over a 12-month period have been associated with average outperformance by the regulated utilities of 10.0 percentage points, while increases of less than 100 basis points have associated with utility outperformance of only 4.2 percentage points.

Exhibit 9: 12-Month Relative Total Return of S&P Utility Index vs. 12-Month Changes in the 10-Year Treasury Yield, Plotted Daily Over 2003-Q3 2016


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  1. Both the relative return of the S&P Utility Index and the change in the yield of the 10-year Treasury were measured over the subsequent12-month period for each week from the beginning of 2009 through the third quarter of 2015.

Source: Dow Jones, Bloomberg, SSR analysis

Exhibit 10: U.S. Regulated Utilities’ Average 12-Month Total Return Relative to the S&P 500 in Various Interest Rate Environments, 2003 – Q3 2016

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Source: Dow Jones, Bloomberg, SSR analysis

Exhibit 11: 12-Month Return of S&P Utility Index, Including Dividends, Relative to That of the S&P 500 Plotted Weekly Against Changes in the 10-Year Treasury Yield, 2009-Q3 2015

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Source: Dow Jones, Bloomberg, SSR analysis

That the relative performance of regulated utilities should be far more sensitive to large than small movements in rates perhaps reflects the qualitatively different drivers of the more extreme moves in bond yields. In recent years, the triggers of the largest moves in Treasury yields have tended to be changes in systemic risk that have caused investors fundamentally to reassess their risk appetite. At these extremes, utilities’ valuations and relative performance have been affected not only by movements in government bond yields but also by changes in the equity market risk premium. During periods of rising systemic risk, such as that following the Lehman Brothers bankruptcy in October 2008 or the European sovereign debt crisis of 2010-2011, U.S. Treasury yields have tended to fall and the equity market risk premium to increase, a combination that was reflected in the relative outperformance of the more interest rate sensitive, lower beta regulated utilities (a pattern that market participants came to refer to as “risk off”). When systemic risk subsequently declines, as occurred when economic recovery took hold in the U.S. in 2009, or in Europe when fiscal retrenchment and monetary stimulus finally stabilized European government bond markets in 2012, U.S. Treasury yields have risen and the equity market risk premium decreased, contributing to the relative outperformance of the less interest rate sensitive, higher beta sectors of the market (“risk on”).

That investor appetite for regulated utilities should swing so markedly in response to changes in international financial and economic risk highlights another set of characteristics that differentiate the risk profile of U.S. regulated electric utilities from that of other market sectors. First, with limited exceptions such as PPL and Sempra, U.S. regulated utilities have little if any exposure to international markets, and their earnings, dividends and valuations are thus generally insensitive to changes in exchange rates,

international interest rates or economic growth and inflation abroad. Second, the critical nature of utility assets and the regulated status of their business have historically been reflected in near continuous access to the capital markets, including during the global financial crisis of 2008-2009. Reflecting these two factors, international financial, economic and geopolitical crises tend to have a lesser impact on regulated

utilities than they do on competitive, internationally exposed sectors of the economy. These periods of rising systemic risk have thus tended to be periods of regulated utility outperformance. Examples include the European sovereign debt crisis of 2010-2011, Russia’s invasion of the Ukraine in 2014, the bursting of China’s stock market bubble in 2015, and the unexpected result of the Brexit referendum in 2016.

More sensitive than other equities to increases in long term interest rates and less sensitive to increases in financial, economic and geopolitical risk, utilities have become the yo-yos of the financial market, grasped by investors in times of economic pessimism and financial and geopolitical instability and then flung away as conditions normalize. This is reflected in recent years in atypical levels of volatility in regulated utility stocks. Exhibit 12 plots the standard deviation of monthly returns of regulated utility stocks, expressed on an annualized basis, against that of the S&P 500. In the three of the last four years, the volatility of the regulated utilities has significantly exceeded that of the S&P 500.

Exhibit 12: Volatility of the S&P Utility Index Compared to the S&P 500, 2009-Q3 2016 (Standard Deviation of Monthly Returns, Annualized)

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Source: Dow Jones, Bloomberg, SSR analysis

Critically, however, the increasingly volatile movements of regulated utility stocks have run markedly counter to those of the broader market. As described above, the causes of utilities’ volatility – swings in investors’ perception of financial, economic and geopolitical risk, and consequently in their appetite for lower risk assets – drive utility stocks in the opposite direction of the broader market. As a result, regulated utilities’ beta, which measures the covariance of the sector’s total return against that of the S&P 500, has been declining and is now at historically low levels. As can be seen in Exhibit 13, the beta of the Philadelphia Utility Index (UTY), which comprises primarily regulated utility stocks, has been 0.7

over the last 10 years, 0.6 over the last five years, 0.5 over the last three and 0.4 over the last 12 months (see Exhibit 11). In the first nine months of 2016, regulated utilities’ beta has been only 0.34.

Exhibit 13: Beta of the Philadelphia Utility Index Relative to the S&P 500

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Source: Dow Jones, Bloomberg and SSR analysis

What weight for utilities in your portfolio?

Where does this analysis leave us? On the one hand, by our estimate, regulated utilities offer expected returns 130-170 b.p. above those of the S&P 500, and do so with a 12-month beta of only 0.4. On the other, the sector’s valuation is extremely sensitive to an increase in long term interest rates, one of the risks that investors fear most. Given these considerations, what weight should utilities have in equity portfolios today?

We believe a framework for this investment decision is provided by our analysis of the sensitivity of utilities’ relative returns to movements in 10-year Treasury bond yields, as set out in Exhibit 10. Given the marked underperformance of regulated utilities during 12 month periods when 10-year Treasury yields have increased by more than 100 basis points, the sector is clearly unattractive to investors expecting a material and sustained increase in long term interest rates. Investors who expect only a modest increase in long term interest rates, however, may wish to have a market or even an overweight position in regulated utility stocks. As illustrated in Exhibit 10, since 2003 the regulated utilities have underperformed the S&P 500 by an average of 140 basis points during 12-month period during which 10-year Treasury yields have increased by less than 100 basis points; against this, utilities seem to hold out the prospect of three to five year returns that are 130-170 b.p. above those of the S&P 500 on an annual basis. If the investor’s expectation of a modest increase in bond yields is fulfilled, the first year of these excess returns may be sacrificed; investors would likely continue to enjoy higher relative returns in subsequent years, however, as well as benefit from the remarkably low beta of the sector, which would serve to stabilize portfolio returns. Finally, those who believe bond yields will remain lower for longer

due to persistently low inflation and GDP growth would be well advised to overweight the sector to capitalize on its potential excess return and very low beta. We assess the factors militating in favor of this scenario in the following section.

In conclusion, regulated utility stocks — with higher expected returns than the S&P 500, and a historically low correlation with the broader market – seem to offer a better risk adjusted return than they have in the past. Under these circumstances, adding utilities to a diversified portfolio of investments should improve the risk adjusted returns of the portfolio.  From this perspective, regardless of their views on interest rates, portfolio managers should maintain at least a marketweight position in utilities and possibly even overweight the sector, depending on the risks and returns of the other investments in their portfolio.

The Outlook for Long Term Interest Rates

In the final part of this note, we will consider whether investors’ concerns regarding a sustained increase in long term interest rates are justified or not. If these concerns are misplaced, as they have been since the onset of the global financial crisis in 2007, utilities may offer a compelling investment opportunity.

To provide a longer term perspective on the risk of rising interest rates, we find it helpful to consider the economic context in which today’s low long term interest rates have evolved, and to consider whether the factors behind the downward trend in rates will persist in the years ahead. To begin, it is worth recalling that the decline in long term interest rates in the United States began 35 years ago; that for five years prior to the global financial crisis of 2008-2009, long term rates were already at levels last seen in the 1960s; and that the ultra-low rates precipitated by the crisis have now persisted for eight years (see Exhibit 12). These facts alone suggest that factors of a much longer duration than the Federal Reserve’s current policy stance are at work.

Exhibit 12: 10-Year U.S. Treasury Bond Yield (Constant Maturity), 1962-2016

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Source: U.S. Federal Reserve

One such factor, we believe, is a secular slowing in the rate of U.S. economic growth. As we illustrate in Exhibit 13, the rate of GDP growth during U.S. economic expansions has decelerated continuously since the 1970s; each economic recovery since the expansion following the 1969-1970 recession has been slower than the last. A principal driver of this five decades long economic deceleration has been a marked slowing in the growth of the labor force (see Exhibit 14): from 2.6% p.a. in the 1970s, labor force growth

fell to 1.6% p.a. in the 1980s, 1.3% p.a. in the 1990s, 0.8% p.a. in the 2000s and was only 0.4% annually during the first five years of the current decade.

Exhibit 13: Compound Average Annual Rate of Growth During U.S. Economic Expansions, 1961-2016

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Source: Bureau of Economic Research

Exhibit 14: Annual Rate of Growth in U.S. Labor Force, 1960-2015

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Source: Bureau of Labor Statistics

 

Slower economic growth reduces the demand for capital, while slower growth in the labor force reduces the expected return on capital investments. That economic growth during the current expansion has averaged only 2.0% p.a., constrained by labor force growth of only 0.4% p.a., has in the view of many economists contributed meaningfully to the current low level of long term interest rates.

Unfortunately, the feedback loop from slow economic growth to low returns on investment appears to have limited capital formation and thus risks becoming self-reinforcing. Many economists see the tepid rate of business investment during the slow economic recovery since 2009 as having contributed to the current stagnation in worker productivity. U.S. productivity growth has averaged 2.2% p.a. in the post-World War II era; over the 20 years through 2015, it has averaged 2.1%. By contrast, over the five years 2011-2016, U.S. productivity growth averaged only 0.6% p.a.; in the first half of 2016, productivity actually declined. In light of the slow growth of the labor force, and the extremely modest recent gains in productivity, the Federal Reserve’s Open Market Committee recently reduced its estimate of the long term economic growth potential of the United States to 1.8%.

These self-reinforcing trends – slow labor force growth, consequently slow economic growth, reduced returns on capital and, as a result, limited capital formation and stagnant worker productivity further constraining economic growth – simply do not point to a significant and sustained increase in long term interest rates.

A second key factor behind the current low level of long term interest rates is inflation expectations. Currently the gap between the 10-year U.S. Treasury yield and the yield on the Treasury’s inflation-protected securities (TIPS) is 1.6%, suggesting that financial markets expect inflation at approximately this level over the coming decade. We should not be surprised; since the current economic recovery began in Q3 2009, the average annual rate of consumer price inflation, excluding food and energy, has been 1.9% (see Exhibit 15). Over the last 20 years, it has averaged 2.1%; over the last 30 years, it has averaged 2.7%. Inflation expectations are anchored at a low level because for the last three decades we have known little else.

That this should be the case despite massive and persistent federal deficits under the Reagan, first Bush and Obama administrations; the need to address the savings and loan crisis of the late 1980s and the global financial crisis of 2008-2009; as well as three wars, is a testament to the independence, economic sophistication and technical expertise of the Federal Reserve. Given the Fed’s impressive performance in containing inflation over the last three decades, the impact this has had on the inflation expectations of economic actors, and the institution’s increasingly conservative monetary stance, a marked increase in inflation, driving long term interest rates significantly higher, seems to us unlikely.

Exhibit 15: Annual Increase in the U.S. Consumer Price Index, Excluding Food and Energy, 1980-2015

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Source: Bureau of Labor Statistics

While it is sometimes helpful to point out the obvious, more helpful perhaps are the insights of a group of academic economists who have highlighted less obvious yet critical economic developments that are likely to keep interest rates low. These economists (prominent among which is the Harvard economist and former Treasury Secretary Lawrence Summers) have identified a series of factors that have contributed to a global excess of savings over the demand for investment:

  1. The rapid growth and extraordinary savings rate of China. China’s economy, now the world’s second largest, is characterized by a gross savings rate equal to nearly 50% of GDP. No country makes a larger contribution to global savings: China’s gross annual savings are equivalent to those of the United States, Japan, Germany and the United Kingdom combined. While China invests most of its savings domestically, it has also exported savings through large and persistent current account surpluses. This has fundamentally altered the global savings/investment balance.
  2. In the wake of 2008-2009 financial crisis, government, corporate and personal savings rates have increased in the United States and Europe, as governments have sought to bring budgets into line with slower economic growth, corporations have eschewed investment in favor of returning capital to shareholders, and households have reduced debt.
  3. The feedback effects of high savings rates on the economy. High savings rates have eroded demand, constrained economic growth, and reduced both the opportunities for and the return on investment, thus aggravating the imbalance between savings and investment.
  4. The failure of governments to address this imbalance through fiscal stimulus has led to successive rounds of quantitative easing by the Federal Reserve, the European Central Bank and the Bank of Japan. The current stream of asset purchases by the ECB and Bank of Japan is sufficiently large to absorb all net new debt issued by governments in advanced economies.
  1. Declining long term interest rates have increased the present value of the future financial obligations faced by pension funds, insurance companies and individual savers, forcing these actors to increase their savings as a result.

Summers in particular is worth quoting at some length on the subject. He has identified three additional factors contributing to the excess of savings over investment:

[First,] increases in inequality and in the share of income coming in the form of profits and retained earnings should operate to raise global saving and reduce real rates. As a rough estimate, the share of U.S. GDP going as wages to the bottom 99 percent of the population has fallen by about 10 percentage points over the last 15 years. If one assumes that this group saves only 2 or 3 percent of their income and that the top 1 percent and the recipients of profit income (often pension funds with automatic reinvestment) save at a 20 percent rate, this alone would raise the overall saving rate by perhaps 2 percent GDP at a given interest rate.

[Second,] the nature of technology and production has changed. It used to take large sums to start a company. Now many are started with less than $1 million. It used to be that cutting-edge technology companies like the automobile companies 75 years ago were large absorbers of cash. Now our most dynamic technology companies like Apple and Google have more cash than they are able to deploy. All of this is relevant to why companies have so much cash on their balance sheets and, so, interest rates are so low.

[Third], reductions in inflation mean that real rates have to be lower to achieve any given after-tax real rate. So, for example, if the inflation rate was 3 percent and the nominal interest rate was 5 percent, the pre-tax real rate would 2 percent. But an individual in the 40 percent bracket would have a 0 percent real after tax borrowing cost. Now imagine a 1 percent inflation world. The same zero after-tax real rate would require a 1.67 percent nominal rate implying a pre-tax real rate of 0.67 percent.[5]

In summary, the factors contributing to the current low interest rate environment are numerous and in most cases persistent. An exception, of course, is the degree of monetary accommodation practiced by the world’s principal central banks. Even in an economic and demographic environment conducive to persistently low long term interest rates, quantitative easing on the scale currently practiced by the European Central Bank and the Bank of Japan may be further suppressing interest rates and keeping long term bond yields below the that economic conditions alone would warrant. Investors concerned about monetary tightening in the United States, or the eventual end of quantitative easing in Europe and Japan, may therefore wish to prepare now to add regulated utilities to their portfolios but to add these positions following the next substantial increase in long term rates.

Appendix: Forecast Growth of the Aggregate Electric Rate Base of U.S. Regulated UtilitiesGrowth in rate base is one of the fundamental drivers of long term earnings growth among regulated electric utilities. Rate base represents the capital invested by a rate-regulated utility monopoly in the supply of a public service (e.g., electricity or gas) and is roughly equivalent to the net depreciated historical value of the utility’s plant, property and equipment, net of the utility’s deferred tax liability. [6] On the portion of rate base funded with equity (a proportion set by regulators at a level deemed adequate to sustain an investment grade rating on the utility’s long term debt, and referred to as the “equity ratio”) utilities are allowed to earn a fair return (the utility’s “allowed ROE”) as determined by regulators in periodic rate cases. Given this regulatory framework, it is common for investors to estimate future utility earnings as the product of rate base, the utility’s equity ratio and its allowed ROE.

As set out in Exhibit 16, a regression analysis of the five year CAGR in electric rate base against the five year CAGR of electric operating income of U.S. investor owned utilities results in an r-squared of 0.31, suggesting that rate base growth explains approximately a third of the growth in operating income among electric utilities. Other key drivers of long term earnings growth include the frequency with which individual utilities file rate cases to adjust their regulated revenues to the reflect the rise in rate base; changes in the allowed return on equity used by regulators to set utilities’ allowed revenues in these rate cases; and utilities’ success or failure in realizing that allowed return through the control of operating and financial expenses. Looking ahead, we expect rate base growth will be an even more important driver of earnings growth as the decline of allowed ROEs levels off and the frequency of rate case filings continues at its current high level.

Exhibit 16: The Relationship of Rate Base Growth to Operating Income Growth at Investor Owned Electric Utilities in the United States, 1993-2013

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Source: FERC Form 1, SNL, SSR analysis

Exhibit 17: Historical and Forecast Growth of Aggregate Electric Utility Rate Base, 2010-2015 v. 2016-2020

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Source: FERC Form 1, SNL, company reports and SSR analysis

U.S. investor owned utilities must file their financial statements annually with the Federal Energy Regulatory Commission (FERC) using a standard format prescribed by federal regulation (FERC Form 1). Aggregating the data across these filings, and using net property, plant and equipment less net deferred tax liability as a proxy for rate base, we have estimated the aggregate electric rate base of the U.S. investor owned utilities. Looking forward, we have forecast the growth of aggregate electric rate base based upon (i) the capital expenditure plans of the publicly traded U.S. regulated electric utilities, (ii) our estimates of future depreciation at these utilities based upon historical depreciation rates, and (iii) our forecast of the growth of these utilities’ deferred tax liabilities, taking into the account the impact of bonus depreciation, the repair deduction, and accelerated depreciation for tax purposes.

Our analysis suggests that the aggregate electric rate base of U.S. investor owned utilities has expanded at a compound annual rate of 6.1% over the period from 2010 through 2015. Looking forward, the capital expenditure plans of the publicly traded U.S. electric utilities suggest that they will expand their aggregate rate base over the next five years (2015-2020) at 6.2% p.a. (See Exhibit 17).

©2016, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. Rate-regulated utilities are allowed to recover their prudently incurred cost of service in rates, including all costs to procure fuel and purchased power, operation and maintenance expense, depreciation expense, income and other taxes, and a fair return on rate base. Rate base represents the capital invested by a rate-regulated utility monopoly in the supply of a public service (e.g., electricity or gas). Rate base may be funded with long term debt, preferred and common equity, and net deferred tax liabilities. On the debt-funded portion of rate base, utilities are generally allowed to earn a return equivalent to their embedded cost of long term debt. A similar approach is to taken the recovery of the cost of preferred equity. On the portion of rate base funded with equity (a proportion set by regulators at a level deemed adequate to sustain an investment grade rating on the utility’s long term debt, and referred to as the “equity ratio”) utilities are allowed to earn a fair return (the utility’s “allowed ROE”) as determined by regulators in periodic rate cases. Because a utility’s deferred tax liability largely represents income taxes expensed but not yet paid, and thus does not represent an outlay of capital, regulated utilities are not allowed to earn a return on deferred taxes. As a result, rate base is generally calculated as the net depreciated historical cost of a utility’s property, plant and equipment net of the utility’s deferred tax liability.
  2. We note that 1.2% annual dilution is broadly consistent with the industry’s financial fundamentals. In an industry with an average allowed ROE of ~10%, and an average dividend payout ratio of ~60%, retained earnings should be capable of funding ~4% annual growth in owners’ equity. If rate base is expected to grow at 6%, however, and the ratio of owners’ equity to rate base is to remain constant, additional equity issuance is required. Since the market capitalization of U.S. regulated electric utilities has recently tended to range between 1.5x – 2.0x their book value, to fund 2% growth in owner’s equity requires 1.0%-1.3% growth in market capitalization.

  3. Reflects the beta of the total returns on the Philadelphia Utility Index (UTY), comprised primarily of regulated electric utilities, against the returns of the S&P 500. Over the last three years, this beta is 0.5.
  4. Growth in corporate earnings might exceed growth in U.S. nominal GDP if growth in the United States’ principal export markets were more rapid. Currently, however, economic growth in Canada, Western Europe, and Japan is expected to lag that in the U.S.; only Mexico is expected to grow more quickly.
  5. Ezra Klein, “Larry Summers on why the economy is broken — and how to fix it,” The Washington Post, January 14, 2014.
  6. Rate-regulated utilities are allowed to recover their prudently incurred cost of service in rates, including all costs to procure fuel and purchased power, operation and maintenance expense, depreciation expense, income and other taxes, and a fair return on rate base. Rate base represents the capital invested by a rate-regulated utility monopoly in the supply of a public service (e.g., electricity or gas). Rate base may be funded with long term debt, preferred and common equity, and net deferred tax liabilities. On the debt-funded portion of rate base, utilities are generally allowed to earn a return equivalent to their embedded cost of long term debt. A similar approach is to taken the recovery of the cost of preferred equity. On the portion of rate base funded with equity (a proportion set by regulators at a level deemed adequate to sustain an investment grade rating on the utility’s long term debt, and referred to as the “equity ratio”) utilities are allowed to earn a fair return (the utility’s “allowed ROE”) as determined by regulators in periodic rate cases. Because a utility’s deferred tax liability largely represents income taxes expensed but not yet paid, and thus does not represent an outlay of capital, regulated utilities are not allowed to earn a return on deferred taxes. As a result, rate base is generally calculated as the net depreciated historical cost of a utility’s property, plant and equipment net of the utility’s deferred tax liability.
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