Utilities ETFs Could be Rebound Candidates

Even with last Friday’s rally, the Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector exchange traded fund, remains is lower nearly 8% year-to-date and labors more than 15% below its 52-week high.

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. Still, some market observers see the recent slide in utilities stocks as a potential buying opportunity.

“On a median basis, U.S. utilities now trade in line with our fair value estimates, the cheapest they’ve been since 2015,” said Morningstar in a recent note. “This is a sharp reversal since Nov. 14, when utilities reached a peak 1.18 price/fair value ratio. Since then, the Morningstar US Utilities Index is down 14% and has underperformed the S&P 500 by 19 percentage points. No other sector has performed as poorly.”

XLU and rival utilities continue to captivate yield-starved investors as the sector sports more tempting yields than are found on U.S. government debt.

“The sharp rise in interest rates, in line with our outlook, appears to be the primary factor weighing on market valuations,” said Morningstar. “The 10-year U.S. Treasury yield recently rose to 2.85%, the highest since January 2014, making utilities’ income properties less attractive. The spread between the 10-year U.S. Treasury yield and the utilities sector’s 3.3% trailing 12-month dividend yield is the tightest since January 2003 and approaching its 25-year average (16 basis points). The spread was 118 basis points as recently as mid-November.”

Additionally, the utilities sector has not gotten much of a boost from tax reform. 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.

“Utilities’ key fundamental risk is a potential cut in regulated returns, which would reduce our earnings growth outlook. However, regulators have been slow to pull back allowed returns in a persistent low-interest-rate environment. Rising interest rates and tax cuts will take some pressure off regulators to cut utilities’ allowed returns,” according to Morningstar.

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