The Move To More Cyclical Sectors Could Weigh On Utilities

The Utilities Select Sector SPDR XLU, the largest utilities exchange traded fund by assets, is up 6.6 percent year-to-date. Although that lags the 7.2 percent returned by the S&P 500, it can be argued the performances delivered by XLU and rival utilities ETFs are pleasant surprises.

After all, the Federal Reserve boosted interest rates in March. At the time, that was the Fed's third interest rate hike in 15 months and many bond market observers believe one or two more rate increases will come later this year.

Even mere speculation that U.S. borrowing costs are moving higher can sap the utilities sector. Historically, no sector is as inversely correlated to rising Treasury yields as are utilities, the eighth-largest sector allocation in the S&P 500.

Some analysts aren't enthused by the near-term prospects for XLU and the utilities sector. In a recent note, AltaVista Research tagged XLU with an Inderweight rating, which according to the firm, implies below average appreciation potential.

“Typically, funds in this category consist of stocks trading at relatively expensive valuations and/or having below-average fundamentals,” AltaVista said.

Indeed, valuations are often high on XLU and the utilities sector, underscoring the price investors must pay to play defense. However, that scenario becomes an increasing concern when Treasury yields rise due to the utilities sector's bond-like traits. XLU's dividend yield of almost 3.3 percent underscores the point as to why income investors like utilities stocks, but it also serves as a reminder as to why the sector is vulnerable against the backdrop of rising rates.

The move to more cyclical sectors could also weigh on utilities stocks and ETFs.

“Although some environmental regulations might be eased in a Trump administration, Utilities have lagged the market since the election as investors shift their focus more towards growth and less in search of yields,” AltaVista said. “Longer term we think distributed generation remains a big threat to Utilities' profitability. Meanwhile valuations appear somewhat rich, but the sector still rates about on par with the S&P 500.”

Year-to-date, XLU has seen modest outflows, but investors have added nearly $330 million to the ETF in the second quarter.