Though many income investors are willing to hold utilities through thick and thin, some analysts are saying it’s time to sell.

Our usual response is to continue quietly collecting our dividend checks, reinvesting what we can, and compounding our wealth over the long term.

But what if the naysayers are right? In the short term, of course, anything is possible. However, we believe they’re wrong.

There are any number of reasons why investors should hang on to their utilities in this environment, including economic data that suggest the U.S. recovery may not be as strong as recent jobs numbers suggest.

But the biggest reason not to sell utilities is the risk of what might happen when the Federal Reserve finally raises rates again. We think utilities’ safe-haven status will continue to prove invaluable until the economy shows it can handle rising rates.

In early March, Christine Lagarde, managing director of the International Monetary Fund (IMF), said Fed tightening could lead to increased volatility in international financial markets, which could undermine stability in emerging markets.

Not to be outdone by the IMF’s doom and gloom, Ray Dalio, founder of the $165 billion hedge fund firm Bridgewater Associates, said in a note to clients that he was avoiding large bets on financial markets for fear that the Fed’s expected change of policy could have unintended consequences, according to the Financial Times.

Dalio is concerned that a Fed rate hike risks causing a 1930s-style stock market slump. In his note, according to the FT, Dalio “likens financial conditions today to those in 1937, eight years after the 1929 stock market crisis and at the end of four years of money printing that had led to a surge in equity valuations.”

We don’t know yet whether history will repeat itself, but Dalio sees a worrisome precedent. Premature tightening by the Fed helped trigger a steep selloff in the Dow Jones Industrial Average, with the market losing roughly a third of its value in 1937.

If comparisons to the Great Depression sound preposterous, consider the following: Martin Wolf, the FT’s chief economics correspondent, recently argued that the reason interest rates are low and will stay low is that we are in a “managed depression.”

A few years back, I corresponded with Wolf and various other economists when my own economic models identified this disturbing global deflationary trend.

What would it take to see an enduring rise in interest rates? Wolf believes that it would require “a marked strengthening of investment, a marked fall in savings and a marked decline in risk aversion–all unlikely in the near future.”

“China is slowing, which is likely to depress interest rates further. Many emerging economies are also weakening. The US recovery might not withstand significantly higher rates, particularly given the dollar’s current strength. Debt also remains high in many economies,” he wrote.

The Utility Sector Pullback Is a Buying Opportunity

Source: YCharts 

If the U.S. economic recovery were to reverse as a result of rising rates, the Fed would have to lower them again.

In a worst-case scenario, the Fed might even have to initiate follow-on rounds of quantitative easing as other countries, such as Japan, have had to do when stimulus efforts failed to revive the economy.

But higher rates aren’t the only potential headwind for the U.S. economy. Tense relations between Greece and Germany could precipitate a Greek exit from the Eurozone, which would weigh on the region’s recovery.

Many economists have argued that growth in Europe is essential to the U.S. recovery since the Continent is one of our largest trading partners.

According to Morgan Stanley, the European economy could contract by 0.2% this year if the currency union crumbles, compared with projected growth of 1% if it manages to stay together.

The bank believes the euro could slide as low as $0.82, around the weakest level ever for the shared currency. And the fair value for European equities could fall by around 10%.

At the beginning of the year, I predicted that utilities could have another strong year, especially if their safe-haven status comes into play. The next few months could prove critical in that respect.

A Question of Valuation

Though utilities would almost certainly benefit from a flight to safety resulting from a weakening global economy, we should still address the matter of how they’ll respond to a rising-rate environment.

In last week’s issue of Utility & Income, my colleague David Dittman showed that during the last Fed rate-hike cycle, between June 2004 and June 2007, utilities actually outpaced the broad market in the six-month period leading up to the first rate increase, and then proceeded to trounce the market during the three-year period that followed.

This comports with the landmark study by Ned Davis Research, which examined the performance of dividend stocks in a rising-rate environment over a 40-year period. The study found that dividend stocks outperformed non-dividend stocks in all environments, while companies that grew their dividends performed even better.

Naturally, a big part of that outperformance is due to the reinvestment of dividends. So if you can afford to reinvest some or all of your dividends, then that will go a long way toward building enduring wealth.

There’s also the question of whether utilities are still overvalued at current levels. After all, they enjoyed an incredible 13-month run prior to their recent selloff.

What many investors forget is that utilities’ returns can be very consistent over the long term. According to Credit Suisse, “The utility value proposition is pretty straightforward: Earnings per share (EPS) growth should be 4% to 6%; while paying a 4% to 5% dividend yield that for many is now growing with EPS; at a 0.5 times to 0.7 times beta; creating a low-risk, high-single to low-double-digit total return.”

As such, the S&P 500’s EPS growth must be pretty robust to stay competitive: The S&P currently yields about 2%, which means EPS growth needs to be about 7% for an equivalent return.

With electricity demand steadily improving in various regions, utilities should generate strong EPS growth going forward.

Beyond that, the recent pullback in utilities has brought valuations back toward the sector’s long-term historical average. And that’s created a buying opportunity.