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
Utilities stocks have been a bit more volatile than usual as their performance appears to be more tied to interest rates than it has been historically. Shares have rallied when bond yields have fallen and declined when yields have risen. 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 slowly heeding that advice and rotating out of the utilities sector, contributing to its underperformance to this point over the past 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. Although recent inflation readings have been relatively weak, we believe a tight labor market and improving economy could lead to rising inflation and 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, much as we’ve seen over the past year during times of rising rates.
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 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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