Utilities exchange traded funds, such as the Utilities Select Sector SPDR (NYSEArca: XLU), roared higher in the first half of this year as investors favored defensive, low beta, income-generating segments of the equity market, but some of the luster on that trade has been lost as highlighted by XLU’s 2.1% decline over the past month.
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?
Some market observers see growing risks to utilities stocks and ETFs, a group usually prized for being less risky than other parts of the equity market. The downside is that utilities stocks are trading at frothy valuations, prompting some concern by market observers over how long the defensive rally can last. 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.
XLU currently shows a 18.69 price-to-earnings and a 1.87 price-to-book. The S&P 500 Utilities Sector is showing a 12-month forward price-to-earnings ratio of 19, compared to its 10-year average of 14 and will above the PE of 16.4 for the broader index.