National Grid has defensive appeal

The prospect of a new US President, a US interest rate rise and Brexit mean that defensive stocks could become increasingly popular. That’s why I’m optimistic about National Grid’s future prospects.

There is no such thing as return without risk. In fact, risk is always present for equity investors. However, there are periods of time when the level of risk faced by investors is higher than usual. I believe that the present is one such period.

Investors face a deadly cocktail of uncertainties

The final US Presidential debate is complete and Hillary Clinton is ahead of Donald Trump in the polls. According to the latest poll, she is expected to win 47% of the vote versus 43% for Trump.

However, there is clearly a long way to go until the election and anything can happen. Moreover, polls can be wrong. Two recent examples in the UK are the EU referendum in June 2016 and the General Election in 2015. Both turned out to be wrong by more than the margin of error, which means that Donald Trump as President remains a possibility.

Whether Donald Trump or Hillary Clinton becomes President, the result is likely to be uncertainty for investors. Both candidates will make changes to fiscal policy and this could impact on the performance of the US economy. It remains in a relatively fragile state and fears surrounding consumer spending levels have grown in recent months.

There is even talk of a ‘restaurant recession’ which could spread into other consumer sectors. Therefore, investors could become increasingly risk-off as the election approaches and even once the new President is in place.

The US election takes place at an important time for the US economy. The Federal Reserve is likely to raise interest rates by 25 basis points to 0.75% before the end of the year according to a recent Reuters poll. Around 70% of economists feel that a rate hike would be implemented before the end of the year.

On the one hand, this is good news since it shows that the US economy is performing well enough to absorb higher interest rates. Unemployment levels have been at or below 5% throughout the last year. This takes them back to their pre-credit crunch level. US GDP is forecast to grow by between 1.7% and 2% per annum during the next four years and confidence in the world’s largest economy is relatively buoyant.

However, a US interest rate rise could cause investors to adopt an increasingly risk-off attitude. It may not make a large difference to the performance of the US economy on its own, but fears surrounding its impact could be enough to choke off a US economic recovery. As was the case with the last interest rate rise in December 2015, share prices could become increasingly volatile. In such a scenario, investors may turn to more defensive stocks.

Brexit is likely to be a constant risk over the next few years – especially for UK-focused investors. We are still in the early days of the process and there could be considerable fear and uncertainty ahead. Sterling could weaken further if confidence in the UK economy deteriorates and the Bank of England maintains a dovish stance on monetary policy.

In such a situation, companies with non-sterling exposure could become increasingly popular. They would benefit from favourable currency translation and perceived lower risk from operating outside of the UK. Further, defensive sectors could become more popular, while higher yielding stocks may also see demand from investors increase as low interest rates suppress bond yields.

National Grid’s defensive qualities make it a port in a storm

Within this outlook, National Grid (LON:NG.) could hold considerable appeal. Its business model is highly resilient and predictable. It is currently three years into an eight year period of UK regulated price control (RIIO). This provides a degree of certainty regarding the company’s financial outlook which is uncommon among its index peers.

In turn, this reduces National Grid’s risk profile and could be a reason why it becomes more popular over the short to medium term. Similarly, National Grid’s beta of 0.5 indicates that it will be less volatile than the wider index in the short run.

National Grid’s high yield may also become more appealing as UK interest rates stay low for longer than anticipated. It currently yields 4.2% from a dividend which is covered 1.45 times by earnings.

National Grid is aiming to increase dividends per share by at least as much as RPI inflation for the foreseeable future. Although RPI inflation has increased to 2% as of September 2016 and could move higher due to a weaker pound, National Grid’s financial assumptions are for it to average 3% over the eight year RIIO period. Therefore, higher inflation may increase the company’s appeal to income investors as National Grid offers a mix of a high yield as well as a real increase in dividends each year.

One potential difficulty on the horizon for National Grid could be its high level of debt. Its gearing is 62% (net debt as a proportion of total regulatory value) and a combination of rising US interest rates and higher RPI inflation may lead to increased debt servicing costs over the medium term. This may cause investor appetite for National Grid’s shares to fall.

However, US interest rates are forecast to be 2.25% in four years’ time and inflation is expected to be below National Grid’s assumption of 3% through to 2020. Therefore, National Grid’s appeal as a defensive, high yield stock should offset fears surrounding its debt levels.

In the coming months, risks such as the US Presidential election, US interest rate rises and Brexit could cause a more risk-off attitude to pervade among the investment community. In such a situation, National Grid’s resilient business model, low beta, high yield and real dividend growth prospects could hold great appeal. In my view, National Grid’s share price could continue to rise following its 10% gain in the last six months. Even if most share prices proceed to do quite the opposite.