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Utilities Sector Rating: Marketperform

By Brad Sorensen

Utilities sector overview

Falling interest rates and a shift in market leadership and concerns that we may be at a near-term peak in growth has led to better performance for the utilities sector and we upgraded the group to marketperform.

Market outlook for the utilities sector

The utilities sector continues to be a bit volatile, performing better when growth concerns resurface and interest rates fall, such as we’ve seen recently, and underperforming when those concerns fade. We don’t believe at this time that the times of outperformance are sustainable, and are concerned that valuation levels for the group are above historical levels, according to data compiled by Yardeni Research. However, a shift in market leadership could continue and last for several more months as peak growth concerns are met with trade concerns. While we still warn against using high-yielding equities as a replacement for fixed income, we continue to rate the sector marketperform.

We think U.S. economic data will continue to show growth, but the rate of growth appears to be slowing, as evidenced by the lower gross domestic product (GDP) growth projections by the Atlanta and New York Federal Reserve banks. This could make the traditionally defensive utilities sector more attractive. Inflation readings have perked up, but remain contained for now, with the Core Consumer Price Index posting a very modest 2.1% year-over-year rise in April. This could entice investors into the higher-yielding utilities sector.

There are some additional positives for the sector, as some of the fundamentals in the utilities sector have perked up. BCA Research recently reported that electricity production was rising, while their valuation indicator has corrected out of overvalued territory.

We aren’t overly bullish on the utilities sector, and it still seems unlikely to be a substantial outperformer in our minds, but enough of the negatives we were looking at have dissipated in our view that we continue to believe a marketperform rating is appropriate given current market conditions.

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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