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.
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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.
[related_stories]The natural gas market has surged over the summer on unusually hot weather that bolstered demand for electricity for air conditioning – about 50% of U.S. households utilize natural gas for heating and cooling. However, the weather conditions are expected to change ahead as temperatures ease.
SEE MORE: Summer Fun for Natural Gas ETFs
The natgas market has been closely tracking weather projections in recent weeks as traders tried to price a shifting outlook on early summer electricity demand for air conditioning. Gas typically dips to a seasonal low during the spring’s mild temperatures before hot summer weather raises demand for gas-fired electricity generation.
“The rise in interest rates has taken its toll on interest rates sensitive sectors over the past two months, and the increase in commodity prices, has added pressure to utility shares, with the XLU falling 10% from its midsummer peak,” adds Seeking Alpha.
For more information on defensive ETFs, visit our defensive ETF category.
Utilities Select Sector SPDR (NYSEArca: XLU)
