The Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector exchange traded fund, faltered late last year and now resides about 10% below its most recent 52-week high, a move that fits the definition of a correction.
Rising interest rates and tax reform are among the issues that hindered the utilities sector in late 2017.
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. The Fed raised interest rates in December, its third such move in 2017 and several more rate hikes are forecast for 2018.
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.
“Utilities are reacting to a negative surprise. In this scenario, participants sell some positions first and re-assess. It’s a knee-jerk reaction and as the situation becomes clearer, price often trades right back to where the decline originated (i.e. the highs),” according to a Seeking Alpha analysis of XLU. “Obviously, this won’t happen if the news is terrible, but from my understanding, the tax bill is not a huge, long-term problem for utilities, just an unwanted complication.”
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.
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.
“I think participants have overreacted to surprise changes to the tax bill and the long-term effects to utility companies will be negligible. I see the decline as a buying opportunity to at least re-test the highs, and make longer-term investments in some of XLU’s top ten holdings,” according to Seeking Alpha.
For more information on defensive ETFs, visit our defensive ETF category.