The past month has seen utility stocks lagging the market, a trend which could continue as economic fears recede. Economic data might continue to improve, prompting investors to move away from the traditionally defensive utilities sector and into more cyclical areas of the market.
Although market expectations for Fed rate hikes in 2016 have declined, rising inflation, along with the stabilization of the dollar, could lead to rates higher than what the market is currently expecting. This would likely result in investors moving out of the “yield-chasing” trade that has helped to boost the sector. Stock valuations in the utilities sector are higher than historical averages, as investors who followed utility stocks’ relatively higher yields may increasingly look to get out of the sector.
The utilities sector’s positive factors include:
Improvement in housing: An improving housing market could lead to higher electricity demand in developing areas, and there are signs that may be occurring as housing stats have started to creep up again.
Attractive dividends: Dividend-paying stocks remain attractive compared to relatively low yields on conservative fixed- income products and defensive, dividend-paying stocks could become even more attractive if economic prospects decline.
However, these potential positives don’t outweigh concerns. As it’s a defensive sector, the utilities sector could be hurt by Federal Reserve policy, as loose monetary policy typically makes riskier assets more attractive. That tends to make the utilities sector less appealing to investors. Moreover, the regulatory environment is a concern as increased demand for “green” initiatives could increase costs for the group.
The utilities sector’s negative factors include:
High fixed costs: Capacity growth has been rising, which has been a sign of underperformance for the sector in the past.
Accelerating economic growth: This would likely make the defensive utilities sector less attractive.
Rising interest rates: This would make the yield-heavy utilities sector less competitive with fixed income investments. Moreover, relatively high debt ratios in the sector could be a problem.
Increase in costly regulations: There could be an increase in the cost of doing business for the utility companies because of the imposition of increased environmental regulations.
Although it can be difficult to resist the year-to-date outperformance of the sector, a stronger economy and valuation issues facing the industry support a rating of underperform for the utilities sector.Risk Warning:
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