Utilities exchange traded funds, such as the Utilities Select Sector SPDR (NYSEArca: XLU), are among this year’s best-performing sector ETFs, but much of that bullishness was seen in 2016’s early stages when investors overtly favored defensive, low beta sectors.
In anticipation of higher interest rates, XLU and rival utilities ETFs languished on the basis that 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.
While XLU resides 6.2% below its July highs, the largest utilities ETF has recently shown signs of strength in the face of adverse circumstances, including the Fed’s first rate hike of 2016 earlier this month. Still, interest rates remain a critical component to utilities investing.
“We’ve long told investors that a wide spread between utilities’ dividend yields and interest rates would dampen the market’s reaction to rising rates. That played out when utilities stocks held firm even as the 10-year U.S. Treasury yield rose to 2.6% as of mid-December and the yield spread closed below 100 basis points for the first time in three years. With a tighter yield spread now, utilities stocks could become more sensitive to future rate moves,” said Morningstar in a recent note.
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.
“We think investors should watch two other metrics to better understand how interest-rate moves in 2017 could affect utilities stocks. The first metric is relative performance. Recent history–including the post-election period–shows utilities underperform nearly every other sector and diversified index when rates are rising. During the past 20 years, utilities underperformed the S&P 500 by an average of 10%, including dividends, when interest rates rose more than 30% in two years. Utilities still posted positive absolute returns in every period,” adds Morningstar.
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.