The S&P 500 is up more than 4% over the past month and more than 7% since the start of the fourth quarter, but the utilities sector is being left behind. Not all of the sector’s laggard status can be attributed to rising interest rates.
The Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector exchange traded fund, is lower by 3.3% over the past month and barely higher during the fourth quarter. XLU recently fell below its 20- and 50-day moving averages.
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.
“It’s not that utilities won’t get a tax cut like everyone else—they will. But because they’re regulated, most will be forced to pass the savings on to consumers in the form of lower power bills, says Williams Capital Group analyst Christopher Ellinghaus, rather than having it filter down to the bottom line,” reports Ben Levisohn for Barron’s.
On the note of tax reform, the benefit to utilities is muted because, as regulated industry, utilities will be forced to pass cost savings from tax reform onto consumers.
“With rates rising, utilities with stronger cash flows should outperform on their ability to grow dividends and maintain payout ratios. Our integrated Outperforms again head the list…On the other side of this coin, we see tax reforms as pressuring cash flows from purely regulated utilities as lower tax rates are shared with regulated customers, although we also expect regulators to approve mitigation strategies that avoid credit rating downgrades,” according to a Credit Suisse note posted by Barron’s.
As the Fed continues raising 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.
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