The Utilities Select Sector SPDR (NYSEArca: XLU) is up more than 13% year-to-date, but looks can be deceiving. XLU is off nearly 6% over the past month as investors have grown increasingly concern about the sector’s lofty valuations and the chances of a rate hike by the Federal Reserve in December.
The fortunes of the utilities sector seem to be tied to the Federal Reserve’s interest rate outlook. Once the Fed eventually hikes interest rates, the higher rates will make fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing. Consequently, utilities may remain flat or underperform other segments of the equities market once rates start ticking higher.
Related: Will the Utilities ETF Sector Keep Shining?
The utilities sector is trading at heightened valuations after investors plunged into the defensive play in search of yield and safety in an environment of historically low yields, slow growth and geopolitical uncertainty.
Heading into year-end, some market observers believe downside remains for defensive sectors, including utilities.
“While all yield-oriented investors will face headwinds, utilities, which produce electricity, have additional challenges, including the rising price of natural gas, and the rising price of coal, which are the two primary fuel sources to generate electricity,” according to a Seeking Alpha analysis of the sector.
Rising natural gas prices could crimp utilities stocks and ETFs.