European Utilities' Headwinds Look Excessively Priced in; RWE and Engie Remain Our Top Picks

Most of the European utilities are well positioned against high inflation due to rising wholesale power prices and the indexation of most networks' revenue to inflation. However, the sector is down by 7% year to date, in line with the market, because of two headwinds: rising government bond yields and political risk. The former makes the sector's dividend yield less attractive. Further, it will increase the cost of debt, which will weigh on European utilities' bottom lines as the sector is the second-most-leveraged in Europe. Renewable developers and southern diversified utilities will be the hardest hit. Political risk varies greatly across countries. As in the European sovereign debt crisis, it is highest in Italy and Spain, and lowest in Germany. France and Belgium stand in the middle and the U.K. power windfall tax was milder than expected. Overall, political risk is stabilizing.