President Donald Trump does not shy away from controversy and that is exactly what was stirred up last week when the president revealed the U.S. will no longer participate in the Paris Climate Agreement. Even with that news, the utilities sector and the related exchange traded funds did not incur significant damage.
Additionally, the U.S. departing the Paris Climate Agreement likely will not affect plans for increased use of renewable energy sources in the coming years. The Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector exchange traded fund, is up nearly 11% year-to-date.
XLU yields about 3.3% on a trailing 12-month, making it and rival utilities ETFs popular alternatives to lower-yielding bond funds. The sector, one of the smallest sector allocations in the S&P 500, is also one of the least volatile. However, those favorable traits do not come free. As previously mentioned, utilities are highly sensitive to interest rates. Additionally, the sector often trades at a premium to the broader market due to its high yield and defensive traits.
“Despite the withdrawal, we continue to forecast U.S. renewable energy capacity doubling during the next eight years. State renewable portfolio standards, or RPS, and other local policies remain the industry’s primary growth driver, not federal environmental policy. Our analysis indicates that renewable energy, including hydro, will grow to meet nearly 20% of U.S. electricity use by 2025, up from 15% now, based solely on existing state RPS,” according to Morningstar.
As 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.
No sector is as negatively correlated to rising interest rates as utilities, meaning the longer the Fed resists raising interest rates, the longer high-yielding utilities stocks and ETFs remain compelling destinations for yield-starved investors.
Still, some utilities stocks, including several of XLU’s marquee holdings, stand to benefit as the move to more environmentally friendly power generation takes hold across the U.S.
“Utilities operating in states with constructive regulation and environmental policy support could realize 7%-9% annual earnings and dividend growth the next three to five years. Best positioned are utilities like Dominion Energy, Duke Energy, American Electric Power, and CMS Energy that are investing billions of dollars in new infrastructure. NextEra Energy and Xcel Energy should widen their lead as the top U.S. renewable energy companies,” notes Morningstar.
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