Whenever the Federal Reserve (Fed) cuts interest rates, investors tend to flock to sectors they believe will outperform due to historical reactions and fundamental reasoning. However, this rate cut is a bit different than those experienced in the recent past as the US economy is more globalized and a bit slower than before.
This will be a different case study, one where rising credit card delinquency rates and increasing auto foreclosures will provide a headwind to the consumer discretionary sector despite interest rate cuts, one where easier financing rates will slow to boost the energy sector now that the 22-month contraction in the manufacturing PMI index has dampened business activity, and one where the dollar is as strong as it was during the COVID-19 pandemic.
When combining these factors, investors should focus on the effect of interest rates on corporate fundamentals rather than on the economic or consumer impacts, as these may be somewhat blurred in the current environment. As for corporate fundamentals, the balance sheet remains in first place, especially given how lower interest expenses may affect utility stocks such as Dominion Energy Inc. D and real estate investment trusts (REITs) with dividends such as Brookfield Infrastructure Partners GDP.
Why utility stocks thrive in a low-interest-rate environment
Utility stocks typically have more debt on their balance sheet than the industry average and as a result will have a higher interest expense on their income statement. For this reason, lower interest rates open up more room on their financial statements due to lower interest expenses, which directly increases earnings per share (EPS).
Since stock prices are driven by their underlying earnings, investors can see how a domino effect can benefit the utility sector if the underlying stocks and their individual balance sheets have enough debt for this factor to become a reality. One such example is Dominion Energy.
This utility stock has as much as 61% debt on its balance sheet, so it's safe to assume that lower rates will significantly impact its ability to generate earnings. With the stock now trading at 98% of its 52-week high, investors can notice how the market has recently rewarded this company with better price action than even the S&P 500.
Additionally, this stock offers shareholders up to 4.6% as an annual dividend yield, which is double the Federal Reserve’s target inflation rate. Since utility stocks also have a subscription-based business model, investors can see how cash flows are more secure and predictable here to cushion any potential market volatility.
That's why Wall Street analysts are forecasting up to $0.75 in EPS for the next 12 months on Dominion Energy shares, a significant jump from today's $0.65 per share or a jump of 15.3%.
Based on these projections, Jefferies Financial decided to initiate coverage of the stock at a valuation of $58 per share, which is roughly its current value, although that could change soon.
Given this fundamentally bullish trend, bears decided to abandon the stock over the past month as Dominion's short interest declined over the past quarter and today showed signs of bearish capitulation. Low interest rates can help utility stocks improve their purchasing power and dividend strength, and other sectors such as real estate also benefit.
Low interest rates boost rental income potential in dividend-paying real estate stocks
This is how lower rates boost the income potential of real estate stocks, especially REITs in standalone asset classes like infrastructure. This is where Brookfield Infrastructure Partners stock comes in.
As financing rates and liquidity become available, acquisitions and additions to the Company's real estate portfolio automatically generate more tenant income and create greater growth potential through the subsequent appreciation of these new properties.
This REIT's balance sheet shows debt at 64.3%, so the same effect applies here in the utilities sector: lower interest expenses lead to better earnings potential.
These fundamental truths led Wall Street analysts to forecast earnings per share of as much as $0.84 for the next 12 months, compared with the current net loss of $0.10 per share.
Fueled by this potential earnings growth over the next 12 months, management is comfortable paying investors up to a 4.8% dividend yield, which could strengthen further as lower interest rates allow the company to expand its property revenues.
Moreover, analysts have also set a consensus price target of $37.6 per share, which anticipates an upside of up to 11.1% from the stock’s current level. Considering that it is already trading at its 52-week high, analysts are directly predicting the stock to hit a new high on cadence with bullish price action and sentiment towards the stock and the sector.
The article “2 Sectors Investors Should Invest In Now That Rate Cuts Are Coming” first appeared on MarketBeat.
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