Defensive stocks such as utility companies could become more popular over the medium term. Instability in North Korea may escalate in the coming months, and this may create an increasingly risk-off attitude among investors.
Higher inflation may also cause utility stocks to become more popular, with their high yields and bright dividend growth prospects having the potential to offer real returns. Within the sector, water service companies may outperform domestic energy peers due to their potentially lower level of political risk.
Uncertain outlook
The situation involving North Korea is highly unstable and very fluid. The future course of action by all countries involved is impossible to accurately predict. Investors are therefore likely to respond to uncertainty with an increasingly risk-off attitude. This could cause share prices to fall in the short run and even lead to a rotation towards more defensive assets.
Utility companies have historically been popular for investors seeking a ‘flight to safety’. Their relatively robust business models and low positive correlation with the economic outlook means their valuations may hold up better than their index peers in the event of a market devaluation.
Inflation
While inflation fell back to 2.6% in June from 2.9% in May, it is forecast to remain relatively high in the medium term. Monetary policy is showing little sign of tightening in the near future, with the Bank of England seemingly more concerned about employment levels and GDP growth than the price level. This could allow inflation to creep above 3% in future months, which may put more pressure on income investors.
A number of utility stocks offer inflation-beating income returns at the moment. Even if inflation rises to above 3% in future, many of them are still likely to offer a positive real return given their dividend yields.
A number of utility stocks offer inflation-beating income returns at the moment. Even if inflation rises to above 3% in future, many of them are still likely to offer a positive real return given their dividend yields. With stable business models, the prospect of dividend cuts also appears to be relatively slim. Therefore, they could offer sustainable income prospects.
Political risk
One potential problem facing utility companies is political risk. The Labour Party has become increasingly popular in recent months, and Jeremy Corbyn is apparently in favour of nationalising a number of sectors. One of these is domestic energy supply, which could increase the risk of holding companies operating within this space over the medium term. Even if nationalisation does not take place, tougher regulations could inhibit profit growth to some extent for domestic energy suppliers in particular.
That’s why water services companies such as Pennon (LON:PNN), Severn Trent (LON:SVT) and United Utilities (LON:UU) could be appealing investments in the long run. The three stocks have dividend yields of between 3.6% and 4.5%, with dividend growth in the next two financial years expected to beat inflation in all three cases. Therefore, from an income perspective they seem to offer a sound medium-term outlook.
Similarly, their defensive business models and reduced political risks versus other utility companies could mean they command a premium valuation. With the outlook concerning the UK and world economy and political scene being uncertain, Pennon, Severn Trent and United Utilities could be sound buys for the long run.
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