Every time the Federal Reserve (the Fed) cuts interest rates, investors tend to flock to the sectors they believe will outperform the most due to historical reactions and fundamental reasoning. However, this rate cut is a bit different than the ones experienced in the recent past, as the United States economy is more globalized and a bit slower than before.
This will be a different case study, one in which rising credit card delinquency rates and spiking car repossessions will place a headwind in the consumer discretionary sector despite interest rate cuts, one that will slow down easier financing rates to boost the energy sector now that the 22-month contraction in the manufacturing PMI index drove business activity down, and one in which the dollar is as strong as it was during the COVID-19 pandemic.
Mixing these factors together, investors should focus on the effect of interest rates on company fundamentals rather than consumer or economic impacts since those may be a bit blurred in today’s environment. By company fundamentals, the balance sheet is kept in the first place, especially the way lower interest expenses can affect utility stocks like Dominion Energy Inc. (NYSE: D) and dividend real estate investment trusts (REITs) like Brookfield Infrastructure Partners (NYSE: BIP).
Why Utility Stocks Thrive in a Low Interest Rate Environment
Typically, utility stocks carry more debt on their balance sheet than the average industry and, as a result, will have a higher interest expense on their income statement. For this reason, lower interest rates open up more room in their financials due to lower interest expenses, directly pushing earnings per share (EPS) higher.
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 carry enough debt to make this factor a reality. One such example can be made out of Dominion Energy.
This utility stock carries up to 61% debt on its balance sheet, so it is safe to assume that lower rates will significantly impact its earning power. Now that the stock trades at 98% of its 52-week high, investors can note how the market has recently rewarded this name with better price action than even the S&P 500.
More than that, this stock offers shareholders up to 4.6% as an annual dividend yield today, beating the Fed’s target inflation rate by twice as much. Since utility stocks also have a subscription-based business model, investors can see how cash flows are safer and more predictable here to cushion any potential market volatility.
This is why Wall Street analysts forecast up to $0.75 in EPS for the next 12 months in Dominion Energy stock, a significant jump from today’s 0.65 a share or a 15.3% jump.
Leaning on these projections, Jefferies Financial decided to initiate coverage on the stock at a $58 a share valuation, which is roughly where it trades today, though that might change soon.
Facing this fundamentally bullish trend, bears decided to move out of the stock during the past month, as Dominion’s short interest declined over the past quarter to show signs of bearish capitulation today. Low interest rates can help utility stocks improve their earning power and dividend strength, and other sectors like real estate benefit as well.
Low Interest Rates Boost Rental Income Potential in Dividend Real Estate Stocks
Here is how lower rates push the income potential for property stocks, especially REITs in agnostic asset classes like infrastructure. This is where Brookfield Infrastructure Partners stock comes into play.
As financing rates and liquidity become available, acquisitions and additions to the company's real estate portfolio automatically generate more income from tenants and create higher upside potential through the ensuing appreciation of these new properties.
This REIT's balance sheet shows 64.3% debt, so the same effect in the utility sector is true here: lower interest expenses lead to better earning potential.
These fundamental truths led Wall Street analysts to forecast up to $0.84 in EPS for the next 12 months, up from today's net loss of $0.10 a share.
Driven by this potential profit growth in the next 12 months, management feels comfortable paying investors up to 4.8% in a dividend yield, which could see further strength as lower interest rates enable the company to expand its property income.
More than that, analysts have also landed on a consensus price target of $37.6 a share, calling for up to 11.1% upside from the stock's current level. Considering that it already trades at its 52-week high, analysts are directly calling for the stock to reach a new high in cadence with bullish price action and sentiment toward the stock and the sector.
