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Inside the Market Analysts just downgraded Enbridge and several utility stocks. Here’s why you shouldn’t act on it

Remember those days when economic forecasts were upbeat and interest rates were rising? Well, they’re over – and the shift to a more subdued outlook has given rate-sensitive Canadian utilities a big lift over the past six weeks.

The sector has rallied 13.7 per cent from its Dec. 24 lows, which is impressive for a collection of companies known for dividends and steady financial results, rather than spectacular growth and innovation. But how much upside is left?

This question gained some urgency on Friday after a couple of analysts downgraded several utilities in response to the recent run-up in stock prices.

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David Galison, an analyst at Canaccord Genuity, downgraded his recommendations on Algonquin Power & Utilities Corp., Capital Power Corp. and TransAlta Renewables Inc., to “hold” from “buy," arguing that the expected total return (with dividends) for each over the next 12 months is less than 10 per cent.

Similarly, UBS analyst Shneur Gershuni downgraded Enbridge Inc. – technically an energy stock, but one with a lot of utility-like characteristics – to “neutral” from “buy.” The analyst argued that recent corporate streamlining and the company’s Line 3 replacement, which will improve the conduit for Canadian crude shipped to Midwestern refineries when the pipeline is completed later this year, are already reflected in the share price, which has risen 20.5 per cent since Dec. 24 (full disclosure: I own Enbridge shares).

However, here’s another way to approach utilities: The rebound has further to run as the market continues to adjust to the idea that interest rates may have peaked.

“Recessionary fears appear to be rising and we believe our names should outperform the broader S&P/TSX Composite in a market where investors are cautious and concerned about a potential recession. Rate declines would be a further tailwind for our sector,” Bill Cabel, an analyst at Desjardins Securities, said in a note.

He highlighted Algonquin Power & Utilities Corp., Boralex Inc. and Northland Power Inc. within his coverage of independent power producers, noting their favourable valuations, dividend increases and growth plans. But it’s not hard to see the upside potential for some of the bigger utilities as well, including Fortis Inc. and Emera Inc.

The sector’s rebound follows a difficult year for utilities in 2018, when the U.S. Federal Reserve raised its key interest rate four times and the Bank of Canada raised its rate three times in response to inflationary pressures.

By the time the utilities sector had bottomed out on Dec. 24, the damage was severe: The stocks were down 20 per cent from their recent high in June, 2017. Their big dividend yields looked less attractive next to rising bond yields. As well, utilities typically have heavy debt loads, which can become burdensome when higher rates translate into higher borrowing costs.

But the new year has delivered some profound changes in outlook. Many observers believe that central bank rate hikes have been moved to the back burner amid slowing economic activity in China and Europe, lingering uncertainty over Brexit, simmering global trade tensions and declining U.S. manufacturing activity.

The Fed acknowledged as much in its policy statement last week, when it said it would be “patient” with monetary policy, erasing a previous pledge to raise rates gradually.

Financial markets now expect that the Fed is more likely to cut interest rates in 2019 than raise them. And the yield on 10-year Treasury bonds, which had risen to a seven-year high of nearly 3.24 per cent in November, has slumped toward one-year lows of 2.64 per cent.

“There has been an utter collapse in market expectations for both inflation and the Fed policy path,” Beata Caranci, chief economist at Toronto-Dominion Bank, said in a note from earlier this week.

Similarly, the Bank of Canada said last month that “the appropriate pace of rate increases will depend on how the outlook evolves.” The statement was widely seen as an acknowledgement that the central bank was less likely to raise interest rates in the first half of 2019, and Friday’s upbeat report on job gains in January did not alter this view.

“Geopolitical uncertainty, tame wage inflation, and regional weakness in Western Canada where Alberta just experienced its worst job loss since 2016 continue to argue for patience,” Matthieu Arseneau, deputy chief economist at National Bank Financial, said in a note.

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That sounds like a good backdrop for utilities. Their big dividend yields, now averaging 4.9 per cent, have regained an edge over rapidly shrinking bond yields. And their business models, based on regulated rates and long-term contracts, appear resilient in the face of economic uncertainty.

Yes, the double-digit gains of the past six weeks will be hard to duplicate. But in an aging economic cycle, it is worth holding on for more.

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