Who Cares if the Fed Cuts Rates
The financial markets and the economy are moving on from central bank inertia.
To pivot or not to pivot: That’s the question the US Federal Reserve is wrestling with on what appears to be a daily basis, flummoxed by practically every data point. But the longer the central bank keeps up its Hamlet act, the more likely financial markets—and by extension the economy—will just tune it out.
Take utilities and electricity producers. For most of 2023, Wall Street conventional wisdom was higher borrowing costs would provoke a sector-wide reckoning—forcing companies to scale back investment plans and projections for earnings and dividend growth along with them.
None of them did. And when it came time in early 2024 to update spending plans, most utilities and other power producers actually raised their five-year projected CAPEX. That includes several companies operating in states where investors have worried regulators would not allow return on investment to keep pace with inflation, due to so-called “affordability” concerns.
Illinois regulators, for example, recently slashed allowed returns on equity (ROE) well below national averages for utilities operating in the state. They also rejected Exelon Corp’s (NYSE: EXC) resource plan to meet the requirements of the state’s new electricity law, claiming the company didn’t take affordability into consideration. And they forced WEC Energy Group (NYSE: WEC) to suspend legally mandated replacement of natural gas distribution mains and pipes pending further review.
The upshot: Both Exelon and WEC Group actually increased five-year CAPEX plans from what they were a year ago, mainly because other states they serve were willing to offer a fair return on investment. For Exelon, the surprising destination is Maryland, which unlike Illinois delivered an amicable rate deal for this year. For WEC, Wisconsin delivered the same.
As a result, the pressure isn’t on earnings at Exelon or WEC. Rather, it’s building on the state of Illinois to treat its utilities more amicably—or else face escalating reliability risk from operating with aging infrastructure at a time when artificial intelligence-capable data centers is rapidly boosting electricity demand.
In fact, higher borrowing costs in general don’t appear to be influencing anyone’s plans regarding AI, including development of data centers. I highlighted the opportunity presented from data center growth for investment in electricity and broadband fiber in the April issue of Conrad’s Utility Investor. And there’s potentially explosive growth up and down the technology value chain as well, from chips to software and a whole new variety of cybersecurity.
Sizzling returns and resulting sky high valuations in big technology stocks resulting from AI fever has rightly made many investors nervous about what happens when the buying momentum inevitably runs out. But that has little or nothing to do with whether or not the Fed decides to cut interest rates this year. Investment continues to flow from arguably the world’s most financially powerful companies—backed by governments anxious to avoid being left behind.
As my friend and colleague Elliott Gue pointed out last week in his substack column “The Free Market Speculator,” oil and gas stocks up and down the value chain have been among the market’s top performers this year. The main reason: We’re in the middle of another leg up in the multi-year “supercycle” for energy stocks that began when North American benchmark oil prices briefly sank below zero at the peak of the 2020 pandemic panic.
Long-term supply continues to lag underlying demand, the result of nearly a decade of subdued investment. And from producers to pipeline owners, the focus of management teams up and down the sector value chain is on doing more with less—i.e., producing the most by using the least amount of capital.
It would be foolish to say elevated borrowing costs have nothing to do with energy companies’ focus on maximizing free cash flow. But it is also true that since oil prices started coming down in 2014-15, the sector has had to learn to live as much as possible without accessing outside capital. And it’s become quite good at it: Even if the Fed started raising interest rates this year, it’s unlikely the policy pivot would have any impact on the industry’s growth or current CAPEX plans—as the best in class that survived the energy downcycle continue to position to profit from the upcycle.
It is fair to say that high borrowing costs were a coup de gras of sorts for the residential solar industry the past couple years. But as my son Nate Conrad has been pointing out from on-the-ground experience in his weekly substack “New Energy Future,” it’s far from the only reason the likes of SunPower (NSDQ: SPWR) have been in a death spiral this year—just a few years after the conventional wisdom was resi-solar would be the death of utilities.
As I’ve been pointing out to readers of my advisory The REIT Sheet, higher borrowing costs have raised the bar on returns for new development. And rate pressure has only tightened the screws on holders of office property loans, including the five regional banks downgraded by credit rater S&P last week.
Office properties, however, were already well into their downward spiral due to pandemic-related pressure, and long before the Fed started tightening monetary policy. Some real estate investment trusts like Boston Properties (NYSE: BXP) were in the middle of aggressive development plans and so were caught out by rising interest rates. But by and large, what the Fed does or doesn’t do won’t have a lot of impact on even office REIT’s investment plans and returns.
So should we even care what the Fed winds up doing? The answer is yes. Their actions (and inactions) do have a real world effect on behavior of consumers, businesses and governments. And I continue to believe we won’t see a sustained return of investor interest in dividend paying stocks until the Fed does pivot to lower rates.
But from the standpoint of the business health and growth factors that ultimately drive investor returns, the Federal Reserve’s current policy of keeping interest rates “higher for longer” is having less and less impact. And when the central bank does finally make up its mind to act, the rally in the best in class is likely to be all the more explosive for the wait.