Utilities Sector Rating: Underperform
What is the utilities sector?
The utilities sector comprises electric, gas and water utilities; independent power producers and energy traders; and companies that generate and distribute electricity using renewable sources.
Utilities sector overview
An improving U.S. economy could create a headwind for the utilities sector, as rising inflation could lead to higher interest rates, reducing the attractiveness of dividend-paying utilities companies.
Market outlook for the utilities sector
Utilities stocks rebounded immediately following the British vote to leave the European Union in June 2016—the "Brexit"—as expectations declined for a Federal Reserve rate hike, and investors again went on a hunt for yield. We urged investors not to chase the rebound, and in fact we've seen weakness in the group to this point in the year as concerns seem to have eased and Fed hike expectations have increased.
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. We also believe that rising inflation could lead to higher rates than the market is currently expecting, potentially resulting in investors moving out of the "yield-chasing" trade that has helped to bolster the sector.
Although it can be difficult to resist performance chasing at times, recent events have shown that can be treacherous, and we continue to believe a stronger economy and higher interest rates support a rating of underperform for the utilities sector.
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 housing starts have started to creep higher again.
- Attractive dividends: Dividend-paying stocks 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 yield-heavy 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.
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