By John H. Herbert

Traditionally, when Wall Street is stuck in a bear market, utility stocks enjoy relatively strong performance. But will utilities maintain their defensive posture when talk of a recession turns into reality? The answer may be no, because the most pressing current economic problems—specifically a declining housing market, cratering credit markets and rising commodity prices—all create special problems for maintaining utility profits.

Utility companies’ current and future net income increases roughly in proportion with floor space. In other words, new homes and additions to existing homes create more demand for electricity and natural gas—not just this year but in future years.

Annualized sales of new single family houses fell to only 604,000 units in December 2007. Compare this to the record level of nearly 1.4 million homes in July 2005. During that same period, large additions were being built onto existing homes across the country. Accordingly, the Dow Jones Utilities Index during this period was posting gains 16 times greater than the Dow Jones Industrial Average.

In December 2007 floor space additions from new homes were so low that they probably didn’t cover the decline in floor space from physical depreciation of existing homes. This declining trend is not likely to reverse anytime soon, based on the large and growing stock of unsold homes.

Furthermore, much of the recent decline in housing activity is associated with credit problems in the mortgage market, and these problems have spread to other credit markets. For example, credit card interest rates and fees for many utility customers have increased. These costs have risen along with inflation in prices for gasoline and other basic commodities that utility customers purchase.

These pressures may affect utilities’ collection rates and bad-debt expenses, as utility customers put off the timely payment of utility bills. They know they can do this because most will continue receiving service even if their payments are overdue. Others will not pay their utility bills at all, because they will abandon houses they can no longer afford. Increasingly late payments and uncollectible bills will reduce utility cash flow, increase short term borrowing requirements and trim income.

The Federal Reserve has lowered the federal funds rate over the last six months primarily to shore up financial markets. Yet utility costs of capital have remained relatively steady, as financial institutions have built a larger spread into loans to balance perceived market risks and offset mortgage-market losses. Moreover, the Fed may need to increase rates in the second half of the year if prices for energy and other basic commodities remain elevated, and if core inflation stays above the Fed’s target level. This could boost utility borrowing costs and reduce utility income. Interest rate hikes appear increasingly likely as economists at the Fed and elsewhere focus more on stagflation, which has re-emerged as an economic bugaboo.

Thus until credit markets, housing markets and inflation stabilize, investors should not count on utility stocks remaining defensive.

Editor’s note: Certainly rising interest rates would put pressure on the utility industry’s cost structure. By itself, that wouldn’t end utilities’ role as a defensive investment. Rather, capital costs are only one factor in a complex set of forces driving up overall costs and complicating utility rate cases—and therefore utilities’ value proposition. To the degree the U.S. economy contracts, regulators will be increasingly reluctant to grant favorable rate treatment for expected capital expenditure plans. Shareholders may need to wait several months longer to ride the wave of a growing rate base. -MTB