A consequence of US interest rate rises is higher borrowing costs for indebted companies. As such, the utility sector saw its valuations come under pressure recently when an imminent US interest rate rise was on the cards, only for valuations to improve again as concerns regarding Chinese growth took over and caused investors to seek out safe havens such as National Grid (LSE: NG) and United Utilities (LSE: UU).
In fact, their share prices have risen by 8% and 10% respectively in the last month alone, which is a very strong performance. Looking ahead, though, it would be of little surprise for their share price gains to be moderated by rising interest rates, since both companies have highly leveraged balance sheets which will be sensitive to a tighter monetary policy over the medium term.
Additionally, United Utilities looking ahead to the liberalisation of the water services market in 2017 and, while it is well-prepared for this, it may cause a degree of uncertainty for the company’s investors in 2016. Therefore, its share price could be held back further by what may prove to be lacklustre investor sentiment.
Despite clouds on their horizons, both National Grid and United Utilities are well-worth buying right now. As mentioned, they are among the best defensive stocks in the FTSE 100 and, with the global economy set to enter a new era of monetary policy tightening at the same time as Chinese growth continues to stutter, holding relatively stable and reliable companies could prove to be a very wise move.
Furthermore, the two stocks pay excellent dividends, with them yielding 4.9% and 4% respectively. This strong, stable cash flow could prove to be highly useful if the FTSE 100 continues to trade at relatively low levels. Additionally, high yields affords the two companies’ investors the opportunity to buy stocks which are undervalued during a potential downturn for the wider index.
Meanwhile, the outlook for Associated British Foods (LSE: ABF) is also rather uncertain. Unlike National Grid and United utilities, it does not offer the same degree of reliability or consistency regarding its financial performance, with its earnings due to fall by 5% in the current year.
Although ABF is expected to recover from this by posting a rise in its net profit of 4% next year, its current valuation appears to be rather excessive. For example, it trades on a price to earnings (P/E) ratio of 33.33, which is around twice the rating of the wider index. Given that it has relatively poor growth prospects, lacks the stability of utility stocks and has a yield of just 1.1%, ABF could realistically see its share price fall over the medium term. Although it may not ‘collapse’, the capital gain of 27% in the last year could easily be reversed in 2016 and beyond.