The utilities sector remains the best performing area of the S&P 500. However, a rising rate environment could cause utilities to underperform. While investors may have enjoyed the ride by overweighting the sector, exchange traded fund investors should also take the time to look under the hood of some of their investment plays lest they end up with a nasty surprise when rates do rise.
The Utilities Select Sector SPDR (NYSEArca: XLU) has gained 17.0% year-to-date, outpacing the 4.7% return in the broader S&P 500 Index.
Investors view utilities as a reliable, income-generating asset that exhibit bond-esque characteristics, which has helped the sector outperform as market volatility spiked and bond yields remained low this year.
The outperformance in utilities has also caused the sector to expose investors to some frothy valuations. According to the Goldman Sachs Group, utility stocks are trading at rich levels after investors took refuge in the defensive sector. Regulated utilities now trade at a forward price-to-earnings ratio in excess of the S&P 500 based on estimated 2017 and 2018 earnings. Moreover, the P/E ratio is also high relative to the sector’s five-year average.
Related: Investors Pay up for Protection With Utilities ETFs
Now, 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.
The Fed, though, may push off on an interest rate hike to July, especially after the unexpectedly weak jobs data. Nevertheless, investors should begin to consider the end game and the potential negative effects a rising rate environment can have on rate-sensitive equities like utilities.