For a second consecutive year, the Utilities Select Sector SPDR (NYSEArca: XLU) and other utilities exchange traded funds are starting the year in strong form. For example, XLU, the largest utilities ETF, is higher by 6.2% to start 2017, but some market observers believe the defensive, high-yielding sector is due for a pullback.

When all was said and done, XLU was one of 2016’s more solid sector ETF bets, but it limped into year end as the Fed rolled its first interest rate hike of 2016 in December. 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.

“But Erin Gibbs, equity chief investment officer at S&P Global, said that while the sector isn’t very expensive at current levels — trading slightly above its three-year forward price-to-earnings ratio — it is expected to yield the worst profits growth this year,” reports CNBC. “In fact, utilities are the only group expected to yield negative or contracting profit growth for 2017, according to S&P Global data.”

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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