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Utilities Sector Rating: Underperform

Submitted by Eric Wilson on February 22, 2018

Utilities sector overview

A growing U.S. economy could create a headwind for the utilities sector, the potential for rising inflation could lead to higher interest rates, reducing the attractiveness of dividend-paying utilities companies.

Market outlook for the utilities sector

The utility sector has been the worst-performing group in the past three months, as good economic growth and higher fixed income rates appear to have moved investors away from the utility sector. We have warned against using equity dividends as a proxy for bond yield income, as the risk characteristics are much different. We believe investors are heeding that advice and rotating out of the utilities sector, contributing to its underperformance over the past months and year.

We think U.S. economic data will continue to show improvement, prompting investors to move into more cyclical areas of the market, away from the traditionally defensive utilities sector. Inflation readings have perked up somewhat, with the Consumer Price Index moving up to a 2.1% year-over-year rise, not extreme, certainly, but the trend is higher, while wages also are moving higher, with the Labor Department’s average hourly earnings number rising to a 2.9% year-over-year gain. The result has been fixed income rates moving higher, a trend we believe will generally continue, leading to a movement away from utilities.

In spite of the recent carnage, some of the fundamentals in the utilities sector have perked up, with BCA Research reporting that electricity production is rising, while their valuation indicator has corrected out of overvalued territory. These positives don’t overcome the negatives in our minds, as valuations haven’t gotten to undervalued levels and positive global PMIs, such as we’ve seen, have historically tended to lead to utilities sector underperformance.

The recent spike in volatility may have encouraged investors to seek the perceived safety of the utilities sector, but we don’t believe that’s the right move. A growing economy and rising interest rates don’t make for a good combination for utilities performance in our mind and we believe underperformance will likely continue.

Factors that may affect the utilities sector

Positive factors for the utilities sector include:

  • Improvement in housing: An improving housing market could lead to higher electricity demand in developing areas, and we're seeing signs that may be occurring as electricity production is growing again.
  • Attractive dividends: Dividend-paying stocks could remain attractive compared to relatively low yields on conservative fixed-income products. And should economic prospects decline, defensive, dividend-paying stocks could become even more attractive.

Negative factors for the utilities sector 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 dividend-paying utilities sector less competitive with fixed income investments. Additionally, relatively high debt ratios in the sector could be problematic.

Clients can see our top-rated stocks in the utilities sector.

Want to learn more about a specific sector?  Click on a link below for more information or visit Schwab Sector Views to see how they compare.

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