Utilities exchange traded funds, such as the Utilities Select Sector SPDR (NYSEArca: XLU), are clinging to double-digit year-to-date gains, but those grasps are increasingly tenuous as the previously hot sector continues sliding while facing the specter of a rate hike by the Federal Reserve next 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?
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.
There are also concerns about the technical positions of XLU, other utilities funds and some of the marquee holdings in those ETFs.
Looking at XLU’s chart, it is clear “that the price has recently fallen below the support of its 200-day moving average and also broke below the neckline of a well-defined head-and-shoulders pattern. This bearish price action suggests that the downward momentum is likely to continue and some may even use the bearish crossover between the 50-day and 200-day moving averages as a signal of the beginning of a long-term downtrend,” according to Investopedia.
The bond-esque utilities sector has also weakened alongside the fixed-income market as Treasury yields rose on the Fed outlook and inflationary pressures. 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: Surging Utilities ETFs
FactSet projects the utilities sector is expected to experience earnings growth of 4.4% in 2016. Consequently, analysts warned that the lofty prices may not be supported by robust earnings growth.
For more information on defensive ETFs, visit our defensive ETF category.
Utilities Select Sector SPDR (NYSEArca: XLU)
