Amid rising interest rates and investors’ preference for cyclical sectors, utilities stocks and the corresponding ETFs are struggling this year. For example, the Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities ETF by assets, is down nearly 6% year-to-date.
Some market observers believe that heightened market uncertainties, which could appear later this year, could bolster the case for defensive sectors, including utilities.
To this point in 2018, “we’ve seen large divergences in performance across the risk spectrum of assets, a situation that’s ‘fine for now,’ but by the end of 2018, that hierarchy will be ‘misplaced’ given a more uncertain outlook, based on tightening financial conditions and growth rates that look ‘peaky,’” reports Teresa Rivas for Barron’s, citing Morgan Stanley’s Michael Wilson.
Rate Impact on Utilities Sector
Nevertheless, the utilities sector remains sensitive to changes in interest rates. 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.
The Federal Reserve raised interest rates for the second time this year last week and is expected to increase borrowing costs two more times before the end of 2018.
Related: 4 Utilities ETFs Shine Amid Market Uncertainty
Morgan Stanley’s Wilson is “yet another voice calling for a potential turn in the consumer-staples sector, and he also upgraded the utility sector to overweight today, citing his expectation on peak 10-year Treasury yields and improving relative earnings breadth,” according to Barron’s.
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.
Year-to-date, investors have pulled $384 million from XLU.
For more information on the utilities sector, visit our utilities category.