Following favorable economic data, the Federal Open Market Committee announced yesterday that it will raise the target federal funds rate by a quarter of a percentage point from the range of 0.25%-0.5% to a range of 0.5%-0.75% on Dec 16, 2016. Presently, the overnight funds rate is pegged at 0.41%.
Consequently, utility stocks tripped, as higher funds rate results in higher ‘cost of capital’. Since financing is an inherent requirement of the Utility sector, rising interest rates are a major deterrent to growth in this space.
Rate Hike & Utilities
The federal funds rate is a benchmark interest rate that determines the rate for financial institutions to lend to each other. A rise in this rate translates to higher borrowing costs for banks who pass on these raised costs to consumers in the form of higher interest rates on loans, mortgages and other financial products.
This cautious yet much anticipated announcement comes after reports of a strengthening labor market and expanding economic activity. Besides, job gains and consumer confidence reports have been robust in the recent months and the unemployment rate has hovered around 5% for the last one year, which is considered healthy. Further, as per recently released data, real GDP has increased 3.2% in the third quarter.
Most importantly, inflation, a key determinant of rates, is showing signs of picking up after running below the Federal Reserve’s target of 2% for years. It is expected to improve to 2% over the medium term as the short-term effects of declines in energy and import prices mitigate and the labor market gains further strength.
As per the Federal Reserve’s earlier statement, “Near-term risks to the economic outlook appear roughly balanced,” which indicates a rise in the inflation rate to the target level. This has also set the stage for a rate hike that the economy will be able to assimilate.
However, a rate hike does not bode well for all sectors of the economy, especially the utilities. Companies in this space are characterized by their capital-intensive nature as they require huge investments for setting up generation facilities, and transmission and distribution infrastructure.
While these companies have been benefiting from a low interest rate environment so far, a rate hike makes this sector far less appealing. This is because the resulting increase in cost of capital will increase cost of operations of the utilities, thereby reducing their profitability. Utilities might have to lower dividends and suspend share buybacks to cope up with the new challenges.
Post the rate hike announcement, the S&P 500 Utilities witnessed a drop of 2.04%.
4 Stocks to Avoid
Here, we have handpicked four stocks with the help of our new style score system. All these stocks have the combination of a Momentum Score of ‘F’ and a Zacks Rank #4 (Sell) or #5 (Strong Sell).
You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
The Momentum Style Score theory states that what has been going down so far is likely to continue to do so in the near future. This indicates the time to avoid a stock that is likely to witness a share price fall. Back-tested results show that stocks with a Style Score of ‘F,’ when combined with a Zacks Rank #4 or 5 underperform others.
Calpine Corporation CPN is a major U.S. power company that owns, leases and operates low-carbon, natural gas-fired and renewable geothermal power plants. The stock carries a Zacks Rank #4 and has witnessed one downward estimate revision for 2016 over the last 60 days. Calpine is down 21.5% year-to-date while the Zacks categorized Utility - Electric Power industry has gained 5.7% during the same timeframe.
TerraForm Power, Inc. TERP, a Zacks Rank #5 stock, is a global renewable energy company. It operates clean power generation assets such as solar, wind, natural gas, geothermal and hydro-electricity. It has seen one downward estimate revision for 2016 over the last 60 days. TerraForm Power has gained 5.6% year-to-date compared with the Zacks categorized Utility - Electric Power industry’s gain of 5.7% during the same timeframe.
Telefónica, S.A. TEF provides fixed-link public voice telephone, mobile phone service, Internet access, data transmission, directories and broadcast media. The stock carries a Zacks Rank #4 and has seen one downward estimate revision for 2016 over the last 60 days. Telefónica is down 19.9% year-to-date compared with the Zacks categorized Diversified Communication Services industry’s decline of 3% during the same timeframe.
Nippon Telegraph and Telephone Corporation NTT provides a variety of telecommunications services, including telephone, telegraph, leased circuits, data communication, terminal equipment sales and other services. Nippon Telegraph and Telephonehas gained 4.18% year-to-date as against the Zacks categorized Diversified Communication Services industry’s decline of 3% over the same time period. However, a Zacks Rank #4 and one downward estimate revision over the past 30 days for fiscal 2017 indicate that the company’s bull run is unlikely to continue in the future.
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